Description

At a Market Cap of roughly $155 million, I think the Eastern Company (ticker: EML) presents a very compelling value in today’s market as one is able to purchase an asset which:

·      Can be bought for roughly 8x normalized 2021 cash flow (FCFE);

·      Has 16-20% returns on invested capital;

·      Is made up of largely stable business models (e.g. the company’s businesses are not as cyclical as they appear to a casual observer);

·      Has cash flows that are highly likely to grow in the next couple of years;

·      Has an aligned management team whose compensation is in part dependent on returns on invested capital (which, from what I’ve seen, seems to be rare), and who will now (as a result of recent proposed transactions / dispositions) focus exclusively on the business’s remaining high ROIC assets;

·      Has a very reasonable probability, on what are in my opinion conservative assumptions, of achieving a 20% IRR over the next 3 years;

·      And likely has little downside (<20%)

Blackstone posted EML in February of this year (https://www.valueinvestorsclub.com/idea/EASTERN_CO/2445046983). I decided to repost the idea as it remains just as compelling, if not more compelling, as when Blackstone posted it given a good Q1 print and more data on demand drivers moving forward. Further, the valuation has declined roughly 25% from its highs post Q1 largely on the heels of what are, in my opinion, temporary factors associated with the company’s Q2 report as well as general market pessimism on future cyclical growth. Investors are being provided with another opportunity here, and I’ve tried to add my incremental 2 cents worth of understanding and detail to Blackstone’s post as the idea remains one of the more asymmetric opportunities I’ve come across.

For some brief context, EML is a conglomerate of 3 primary businesses: Big 3 Precision, Eberhard Manufacturing, and Velvac. Big 3 precision produces blow molds for consumer packaged goods companies as well as manufacturing equipment for auto makers. Eberhard Manufacturing primarily produces locking equipment for a variety of industries. Velvac produces mirrors and sighting systems for Class 8 trucks and RVs. EML also has other businesses that management recently announced are going to be sold off in the next year (as Blackstone mentioned would likely happen). Here are some brief financials only for the three above remaining businesses:

Market Cap: $155 million

Cash: $17 million

Debt: $57 million (pro forma for the recently announced plan for disposing of assets)

Enterprise Value: $197 million

EBIT, EBITDA

2019: $18.2 million, $22.7 million

2020: $16 million, $22.8 million

2021 (Annualized and Normalized, described further below): $22.3 million, $29.3 million

EV / EBIT, EV / Unlevered FCF

2019: 11x, 11.9x

2021: 9x, 10x

Market Cap / FCF (levered):

2019: 10x

2021: 8.3x

** I would note that there is roughly $3.5 million of excess depreciation on the EBIT figures above relative to required maintenance capital expenditures

** Also note that the 2019 figures have not been adjusted for the company’s largest acquisition to date, so the highly accretive acquisition is not included in the 2019 figures (e.g. by paying 10x the 2019 figures above, one is actually paying mid to high single digit multiples on 2019 figures for the new consolidated entity when you adjust for the acquisition).

(1) There are a few reasons that I suspect are behind the recent pullback in valuation that are providing the current opportunity:

(A) The “Peak” Growth narrative. As we all know, the “Peak” Growth narrative has been part of the reason for some recent underperformance in some cyclical stocks. EML was not immune to this. However, regardless of if the narrative is true, I believe it to be unwarranted as EML is not as cyclical as it initially appears (e.g. on an initial review, one would assume cyclicality because of its ties to the automotive sector).

Of the EBITDA the company currently generates, roughly 45% comes from Big 3 Precision, roughly 30% comes from Velvac, and roughly 25% from Eberhard Manufacturing.

The primary drivers of Big 3 Precision are new vehicle model launches and the re-design / new model launches of CPG products. What is necessary to highlight about these drivers / Big 3 is that they have little to do with the volume of product that their customers (e.g. OEMs, CPG companies) sell. Because end market volume (e.g. the cyclical part of the products they touch) is not a factor, Big 3 has fairly stable demand through the economic cycle. Management, when they acquired the firm in late 2019, stated that Big 3 Precision’s sales for the previous 5 fiscal years grew at a double digit annual rate. This is notable because from 2015-2019, new vehicle model launches actually declined from 48 new vehicle models launched in 2015 to 35 new vehicle models launched in 2019. Further, total sales (in units) of trucks and passenger car sales in North America went from 17.4 million in 2015 to 17 million in 2019. This suggests one of two things: either the company gained share in its automotive business, or the CPG focused side of the business grew at a significantly faster clip than the decline in the auto business. 

On the topic of new vehicle models, from 2002-2021, the average number of launches was 40 per year. In 2009, that figure reached 32 (the low of the 20 year span). That’s only 20% less than the average, suggesting further that, despite the economic environment, OEMs still try to introduce new products to compete and gain share. I suspect a similar dynamic exists in the CPG space. Big 3 remains quite resilient in any environment, as could be seen especially in 2020 with the company continuing to remain substantially profitable.

Velvac is probably the most cyclical of the three businesses as it is in part tied to the volume of Class 8 truck production. Mirrors / sighting systems don’t get sold unless trucks are produced. Nonetheless, something that is overlooked here is that roughly 1/3 of Velvac’s sales comes from aftermarket sales – you either need to replace a mirror or you don’t, and most of the demand here is maintenance expense on the part of truckers. To this end, the average age of trucks is an important factor in driving aftermarket sales, and the average age of Class 8 vehicles has risen from 11.2 years old in 2008 to 12.8 years old in 2018. As Velvac accounts for roughly 30% of consolidated EBITDA, once you strip out the aftermarket sales portion of Velvac, there remains roughly 20% of cyclical EBITDA contribution to the consolidated entity.

With the Eberhard business unit, it’s harder to get a clear picture. The unit sells locking systems and other products to a variety of industries ranging from automotive to medical to POS systems. No breakdown of financials is available by industry, but I would imagine similar demand dynamics to Velvac (e.g. demand is partly driven by discretionary spending, and partly by aftermarket sales). For the sake of conservatism, one could apply the same cyclicality breakdown as with Velvac – roughly 1/3 of demand is cyclical with the remaining portion being more maintenance driven.

To recap, Big 3 EBITDA contribution is 45%, Velvac is 30%, and Eberhard is 25%. Applying these percentages, one could assume that of consolidated EBITDA, roughly 35% could be said to be cyclical, with the remaining 65% generated by relatively less cyclical / stable demand. The “Peak” Growth narrative is really only applicable to a comparatively small portion of EML’s consolidated operations, and therefore the extent of the recent sell off, at least as it relates to this narrative, seems unwarranted. One could also look at 2019 cash flow numbers (pro forma for the Big 3 Acquisition) and see that today’s price represents ~8x 2019 cash flow; so, removing the ‘benefit’ of post Covid growth (e.g. Class 8 / RV production and orders), and assuming we return to 2019 levels, one is still paying a cheap multiple for the company.

(B) The company has continued to report significant inflation in its raw materials / freight rates (not surprisingly) since Q4 2020, and gross margins took a hit going from 25% in Q1 2021 to 23% in Q2 2021 (GMs in Q4 2020 were 22%). My view is that these gross margins should be temporary (GMs for 2019 were 28%), as it can reasonably be inferred that it is the rate of increase in costs and volatility, and not the price level, that has held them back. While I try not to opine too much on any specific quarter, this can be seen from the gross margins in Q1 of this year – despite costs increasing the fastest in this quarter (roughly 50% for steel and freight rates) of the past 3, gross margins were the highest. Some of the fluctuations here are also probably due to mix shifts (some projects in some segments have long lead times, but it is not disclosed as to how delivery breaks down quarter to quarter) in what is delivered during the quarter, but nonetheless illustrates the point. By no means am I an expert on inflation, but I don’t think shipping rates / raw material costs can increase 30-50% intra-quarter forever, and it seems to me that the marginal investor here is projecting this in perpetuity.

As the rate of cost inflation starts to temper and the company’s price increases catch up, I would expect that gross margins move back to a more normalized 25-26% level, which I would note is below the 2019 figure of 28%. However, if I’m wrong and new normalized gross margins are 22%, there shouldn’t be much downside: that would mean annualized cash flow for 2021 would be roughly $13 million; 10x that figure gives us a $130 million market capitalization for downside of roughly 20% relative to the current price. Further, 10x cash flow is very cheap given the quality of the company and its outlook, as is described further below. In short, downside is substantially protected, even in a particularly bad case, at the current price.

Also, if one looks to the prices of those same raw materials from 7/4/2021 to today, their rate of increase has started to moderate – hot rolled steel prices have increased roughly 7% and cold rolled steel prices have increased roughly 10%. The exception here is shipping rates, which have continued to increase, and which has likely contributed to pressure on the stock.

During the quarter, the company also announced a more direct effort of selling their remaining ‘bad’ / non-core businesses. This is addressed later, but I don’t think this was the cause of the sell off.

(2) Given that investors would be paying roughly 8x normalized 2021 FCFE at the current stock price, investors are attributing no value to EML’s future. This is despite the fact that there are clear growth drivers on the horizon.

-- First, as it relates to Big 3 Precision (EML’s largest operating business), 2022-2024 should be important years in terms of growth, primarily because of the outlook for new vehicle model introductions. Bank of America recently put out the following slide detailing projected new vehicle launches by OEMs. Vehicle launches are expected to rise 50% in 2022-2025 relative to their 20 year average during the period of 2002-2021, partly driven by EV introduction and production. This should be a boon for Big 3: If they keep the same market share and tread water, they should grow. If they continue to win market share (which it appears they had been doing from 2015-2019), they should do even better. This dynamic should be a win-win for the business unit.

-- Second, as it relates to Velvac, recent data suggests that Class 8 truck orders are running well above trend as companies try to capitalize on high freight rates. Preliminary Class 8 orders for August (the month where Delta uncertainty really took hold) were nearly double what they were in August of last year, and in line with October 2020 orders. This is notable as it (1)  represents a significant step up from July (roughly 50% sequential increase), (2) is despite OEMs continuing to delay booking 2022 orders as supply chains are still under pressure, and (3) is roughly 4x the amount of orders in August of 2019. Certainly the argument could be made that Velvac’s projected performance in such an environment should be discounted (“this won’t last forever”), but at < 50% of consolidated EBITDA and with 1/3 of its sales coming from the aftermarket I’m not too worried about that interpretation. Further, more trucks on the road using Velvac’s sighting systems should serve to lift the water level of Velvac’s aftermarket sales in the future. The RV market also continues to boom. Also, if you want to be conservative and instead assume a return to 2019 levels (which was also when RV sales were at their lowest since 2015), downside should be limited.

-- Third, and as Blackstone mentioned, the company’s Eberhard manufacturing division was the result of a combination of Eberhard and a different subsidiary called Illinois Lock. Management recently stated they are continuing to work on consolidating the two business units and streamlining their operations. While I don’t give credence to ‘found synergies’ as a result of this consolidation to my valuation, there is nonetheless the potential that management continues to make operations more efficient and thus squeeze out incremental cash flow.

-- Fourth, and perhaps most importantly, Blackstone’s mention of management aggressively continuing to divest from non-core businesses remained true during the most recent quarterly update. Management stated they are actively trying to divest of their last remaining non-core assets and for the first time declared them discontinued operations, which management thinks can be sold for roughly $25 million in after tax proceeds over the next twelve months. This is meaningful for two primary reasons:

(1)   It suggests that management is confident they can get roughly 10x cash flow for these businesses;

(2)   And as a consequence it suggests that 10x cash flow is an absolute floor for the remainco, especially considering the fact that the remaining businesses are significantly better than the discontinued operations across every metric. To list a few examples:

Because there were no easily identifiable precedent transactions for similar businesses to the discontinued ops, we are relying on management’s estimate as to their private market value. Understanding the risks there, I feel comfortable underwriting 10x cash flow as a reasonable estimate of fair value for the discontinued ops as, in today’s interest rate environment, that type of yield is certainly reserved for, generally speaking, poorer businesses. Indeed the discontinued ops are on the poorer side given the above metrics. To me it seems that this is nonetheless a reasonable barometer of value, at least as it relates to the remainco, which is to say that one can be virtually certain that the remainco is most definitely worth more than 10x cash flow, and yet the market is pricing it at 8x 2021 normalized FCFE.

Currently, there is also no reason to believe that management would be dishonest / mislead shareholders. I view them as quite savvy, and they have clearly moved the business in the right direction since they took it over in early 2016. Prior to their arrival, the business was generating ~$7 million in cash flow with ROICs of 9%. As of 12/31/2019, the business, pro forma for the Big 3 acquisition, generated cash flow of ~$20-22 million with ROICs of 16%+, and over the next year or two should be even higher given the disposition of lower quality assets and growth. As far as I can tell, they have been great stewards of capital thus far, and it does not appear that that has changed.

Moving forward, the sale of these lower quality businesses will allow management to exclusively focus on the higher quality assets and optimizing their cash flow / capital expenditures. While ‘management focus’ is a qualitative factor, it should lead to value creation in the long run, and certainly provides some ‘upside optionality’ to the remainco as it grows through more focused management and the upcoming demand drivers.

(3) Valuation – what is EML worth? My view is that the company is worth at least 13x cash flow, given (1) the quality of the assets and (2) in today’s interest rate environment, a 7.6% yield on a relatively stable business that is likely to grow and has > 15% ROICs does not seem to be too optimistic.

At 13x cash flow, the implied market cap is roughly $250 million, or roughly 56% higher than the current market cap of $155 million. Of note, this valuation does not account for the aforementioned growth drivers which will take place over the next couple of years, or the growth that the company’s largest segment (Big 3 Precision) has seen over the last 5 years prior to the pandemic.

One could also attempt to derive a SOTP on cyclical vs. non-cyclical cash flow. Capitalizing the roughly $12.3 million in cash flow coming from the less cyclical parts of the business at 13-14x does not sound too demanding (note also that no future growth is accounted for). That would be a value of $160-172 million, at least the current market capitalization. This is to say that the market currently views the cyclical parts of the business as having negative / no value, despite the fact that (1) these units produce positive cash flow and (2) they are poised to grow over the next few years. Again, to me this shows the relatively little downside inherent in an investment at these prices.

Let’s say the cyclical cash flow is worth roughly 8x, which would equate to a value of $53 million. Adding the two together and one gets a valuation of $172 million + $53 million = $225 million, or roughly 40% upside from today’s price. Also note here that we are capitalizing less than peak ‘cyclical’ cash flow at 8x – this cash flow should increase with Class 8 production fulfilling the currently very high order volumes over the next year or two.  

Each valuation points to a ~50% average return from the current stock price. If we also conservatively assume that over the next 3 years the company does not grow (despite all of the current signs) and generates roughly $13 million per year (e.g. the non-normalized 2021 annualized figure), then the company will produce $39 million in FCFE over 3 years, or roughly 25% of the current market cap. Total return would therefore be ~75% over the course of 3 years, which represents an IRR of roughly 20%. If one assumes that the company’s earning power normalizes this year and generates roughly $18 million (which is still probably a conservative normalized figure) over the next 3 years, the IRR is closer to 23-24%.

Another way to look at valuation here is from an EV perspective. Current EV is roughly $227 million. Normalized, unlevered cash flow should run at a minimum of $21 million. Management stated that, once the discontinued ops are sold, the proceeds will be used to pay down debt. That means pro forma EV is ~$200 million, which puts the current multiple at 9.5x cash flow. At 13x cash flow, the implied EV would be $273 million. Less pro forma debt of $57 million plus $17 million of current cash, the implied market cap is $233 million, or 45% upside. Adding in, say a conservative $16 million of unlevered cash flow in the following 3 years, and the implied market cap becomes $280 million, which is a 75% return and IRR of 20%.

This is all attractive given (1) the assumptions used, (2) in my opinion, the price of the market does not currently provide a reasonable probability of achieving such a return over the next few years, and most importantly (3) the little downside inherent to the investment (perhaps less than 20%). Not surprisingly, I think there should be very reasonable ‘upside optionality’ as the growth drivers start to play out, which makes the investment here more attractive. In today’s market this seems like an above average, asymmetric bet to take.  

I will note that EML is closely held and illiquid, and as such is probably most suitable for smaller funds. My interpretation is that this dynamic also contributes to the current valuation as the security has likely been overlooked, and any small amount of selling / buying drives the price of the stock here quite dramatically.

DISCLAIMER: The Author currently holds a long investment in the securities of the Eastern Company (Ticker: EML) and stands to benefit should the price of the security rise. The Author may buy or sell long or short securities of this issuer and makes no representation or undertaking that Author will inform the reader or anyone else prior to or after making such transactions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note and disclaims any obligation to update such information. The views expressed in this note are the sole opinion of the Author, which may change at any time. The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the above note. This written note should not be construed as a recommendation to buy or sell any security or as investment advice.

Catalyst

Growth of Big 3 Precision as new vehicle model introductions take place 

Rate of cost inflation begins to moderate 

Execution on sale of discontinued operations