Description

Acme United manufactures and sells primarily cutting and measuring tools (i.e. scissors and rulers) and other school and office supplies, and has 95-100% of the distribution of certain products in nationwide chains like Staples and OfficeMax. This strong position provides excellent margins, ROE, and cash flows in their core business, and they are trying to take this formula to Europe, where they are currently showing losses. I believe the problems in Europe are surmountable, and that the stock is substantially underpriced considering a "not excellent" outcome in Europe, and if they gain gain traction in Europe, the stock is very cheap.

Acme regularly shows up on various "best small companies" lists (i.e. Forbes, Business Week, etc) due to its excellent financial performance. The market cap is currently around $50M, which I understand is small for some VIC regulars, though it is possible to get a position -- watch for high volume days, which do occur. The business is straightforward and easy to understand.

Acme was organized as a partnership in 1867 and incorporated in 1882. The company and its execs have their roots in the medical supply business. In March 1999 they sold their Medical Division, which sold things like medical instruments and bandage products, to focus on consumer products. Now they sell primarily scissors, cutting devices, rulers, pencil sharpeners, and first aid kits. The next time you are in your local Staples, look at the scissor and ruler offerings. 100% of them will be from Acme, their "Westcott" brand. Having a "category monopoly" with nationwide distribution is what explains their excellent domestic results.

The business and the financials are refreshingly simple and easy to understand. I'll let the 5 year history speak for itself. Numbers in 000's, except for percentages and per-share figures.

	2006	2005	2004	2003	2002
Net Sales	$56,863	$49,947	$43,381	34,975	30,884
Change %	14%	15%	24%	13%
Gross Margins	43%	45%	45%	38%	34%
Book Value	18,131	14,065	9,623	9,132	8,479
ROE	21.4%	20.9%	33.6%	13.4%	7.8%
Net Income	3,886	2,937	3,238	1,222	660
European losses	1,017	159	664	859	500
Total Assets	35,021	28,194	22,967	19,743	17,614
LT Debt	10,221	5,577	1,434	2,752	2,032
EPS (Diluted)	1.05	0.78	0.85	0.34	0.19
Dividends/Share	0.12	0.11	0.06	-	-

You can see the excellent top line, bottom line, margins, ROE, and growth in book value. Remember that the earnings and ROE figures are after the significant losses in Europe (more on that in a minute). In terms of one-time items and adjustments, there was a one-time charge of $1.5M (about $0.43/share) in Sept 2005 due to a warehouse demolition. The property had already been written off the books by 1998. There was a small acquisition for $446K in 2004. Sales in 2006 were 78% US, 13% Canada, and 9% Europe.

Earnings in 2005 were suppressed by the warehouse demolition, and in 2006 by unusually high European losses which I don't expect to last forever. So earnings for the company have arguably been suppressed for 2 years, and even so, the figures are good. Without these negative effects, the numbers would be excellent.

Insiders

Execs and directors own about 28% of the stock, and there was insider buying in April 2007. Management comp is reasonable in the context of the entire market (i.e. management salaries of around $150-385K plus bonuses and options), though perhaps a bit high in relation to revenues and earnings, a common problem with micro-caps. I believe management truly works for the benefit of shareholders.

Debt and Working Capital

The company is both growing rapidly and seasonal, and they usually load up on debt to boost inventory before the hot quarters (Q2 and Q3, think back to school). They also used debt to pay the warehouse demolition costs in 2005. Given the strong cash flows, reliable sales and low cost of debt they can obtain, my take is that the debt financing makes perfect sense as a working capital strategy, and helps to boost ROE. Debt is generally on good terms, a revolver at LIBOR+1%, and long term debt with an average fixed rate of 6.5%.

The current ratio for 2006 was 5.31, and inventory turns are around 2.2 to 2.6. Working capital is strong and well managed. This bears watching as the company tinkers with its product mixes, but I believe that this is very well managed, in fact one of the areas where management excels.

US

Domestically, Acme simply has to play a great hand. They have category dominance, nationwide distribution, and high returns on equity and capital, and are maintaining their lead by spending on R&D and making acquisitions. In the last CC, the CEO said that 30% of sales come from new products. Their iPoint pencil sharpener is an example, which won prestigious product design awards (and is featured on the cover of their annual report). They strive to establish proprietary, manufactured products and stay out of commodity markets.

Notes from the last CC: they have 100% of the scissor and ruler market at Staples, and a "very strong" position in the first 8 safety categories in commercial channels.

Europe

The European operations are the big variable and the crux of this story. I have added a line item for the European operating losses in the financials above to highlight this. Note that the losses had been declining for 3 years from 2003-2005, and suddenly spiked in 2006, and about half of that was in Q4, which was a very unpleasant surprise. Also note that the earnings figures are after the European losses, so for instance in 2006 they showed $3,886 of net income ($1.11 per share) and ROE of 21% even after $1,017 of losses in Europe.

The European losses are the elephant in the room, and are a sore spot among the investor community. This came up in most recent conference call (where Jeff Matthews of "is not making this up" fame made an appearance). One caller was clearly throwing in the towel, being clearly disappointed by the spike in losses after years of the losses seemingly being contained (and recurring promises from management to that effect). I suspect that the big sell-off on the day of earnings was due to this sentiment. However, I think it is very unlikely that these losses will continue indefinitely. Management seems very sensible and capable, and I believe they will eventually either get it right or quit.

In Europe, they are changing the product mix, have made management changes, and are cutting costs. Here are my notes from the 2006 Q4 CC (paraphrased, not an exact quote): "We had a bad year in Europe. The good news was that we added $1M on a few key customers. Unfortunately we spent a lot of money on those sales (air freight, packaging, labor, freight costs). We did that to get the business but have made some changes. We saw high startup costs with some key accounts, but have already seen margin improvement in 2007. We have not been able to leverage our product development in Europe as well as we have in the US. We are not satisfied and are still working."

Two things are clear: 1) management is absolutely committed to trying to make things work in Europe, and 2) they are still searching for the right formula. They have changed their products, manufacturing, sales strategy, shipping & distribution strategy, management team, and keep making changes trying to make it work. Clearly they are trying to take their successful domestic formula to Europe. Two more things are clear: 1) they are still able to post very good numbers while absorbing these losses, and 2) if they can gain the same kind of traction in Europe that they already have in the US, the stock is undervalued by a very wide margin.

The numbers bear this out plainly. In the absence of losses in 2006, earnings would have been 26% higher, and the stock would be trading at a current P/E of 10 and their ROE in 2006 would have been 27%, very cheap figures for a company with the excellent 5 year financial history. If they were able to obtain even modest profits in Europe, the numbers would be even better. If they are able to, within 2-3 years, achieve the same success in Europe as they have in the US, the numbers are better still.

2007 forecasts: $65M in revenue (representing growth of 14%), $4.7M in earnings (growth of 22%), $1.25 EPS. With the stock at $14.62, this puts them at a forward P/E of around 11. This is for a company that has grown revenues and earnings at 12-15%+ with ROE of around 20% for 5 years running, with an easily identifiable "moat".

I believe that the company, as it stands now with European losses at the blowout levels, is still cheap. I believe that the losses in Europe, while unwelcome and substantial, will not last forever. This is in essence a very simple business, with clearly proven demand and success in the US, and should translate well to the European economy once they get the formula right.

It is hard to see a lot of downside from here, since the European losses seem to be about as bad as they can be, meanwhile the domestic operations are still strong. The company has no problem showing excellent profits while they tinker with Europe, and the stock seems to be valued as if Europe will never add any value and will always show losses. So, probabilistically speaking, there is very little chance of downside, a good chance of upside, and some chance of extraordinary upside.

Management has never made any indication of putting the company up for sale, but I believe they would make an excellent acquisition, due to their simple "pure play" business, cash flows, and ability to support leverage.

Q1 update:

- European losses declined from ~$220K to ~$185K. Admitted that they were "derailed" by European losses last year.
- Demand for the new iPoint pencil sharpener is strong and they anticipate strong results with it in Q2 and Q3 (based on orders they have already received).
- Estimated EPS for the year will be $1.25. This puts them at a forward P/E of about 11.6.
- The demolition of the Bridgeport property is complete, but there are tenants paying rent and providing about $170K of free cash flow. They are looking at options for developing the property. Development may cost $140-170K.
- Bought back $400K of stock during the quarter "in the 13.90's", and have 100K shares remaining on the authorization.

Catalyst

- Discontinuance of European losses (which have already improved in Q1 2007), either through success or by discontinuing those operations, and simply value being discovered, this is a rare cheap stock in this market