Description

National Presto (NPK)

Summary:

• NPK’s monopoly-like position has been eliminated by the US government, shifting its reliance on NPK as a sole-source for 40mm ammunition to using multiple manufacturers.

• A recently completed large 2016 foreign military order for 40MM ammunition likely inflated NPKs Defense revenues by over 50% during Q4 of 2016 and the first nine months of 2017.

• NPK’s loss of next generation 40MM training contracts coupled with reduced military spending on non-training 40mm rounds are likely to result in significant declines in profits and revenues in 2018 and beyond.

• NPK’s household appliance business continues to deteriorate, being negatively impacted by e-commerce leading to losses.

• We believe NPK has 45% to 60% downside from current levels.  

Last year we invested in National Presto (NYSE:NPK), a small cap company founded in 1905 and headquartered in  Eau Claire, Wisconsin.  NPK has been a value favorite for decades and was even mentioned by Ben Graham in The Intelligent Investor and Warren Buffett in one of Berkshire’s early shareholder letters.  When we initiated our position in NPK last year, it operated three segments: Defense Products, Housewares and Absorbent Products.

Over the trailing twelve months, the defense segment generated about 70% of NPK’s revenues and 90% of its operating profits.   Prior to this year, the defense segment had a very solid business as the sole source prime contractor of 40MM ammunition to the US government. Typically, the Department of Defense tries to avoid having a sole source of production. However, prior to 2017, the Army set aside the 40mm contract award for companies that qualified as “small businesses.” NPK was able to be in a monopolistic position because of its status as a “small business” coupled with its scale and experience producing 40MM ammo.   To qualify as a “small business” NPK had to operate with less than 1500 employees and it managed to do so by narrowly focusing its product line on 40MM ammunition. Outside of NPK, no other company had both the small business designation and the capability and scale to economically meet the army’s 40MM needs. The “small business” designation allowed NPK to generate outsized operating margins of 22-24% for its ammunition sales vs. other ammunition suppliers like Orbital ATK who had operating margins of 10-13.5%.   Even branded consumer based ammunition manufactures like Winchester only manage to generate operating margins of 17-18%.  

The Housewares segment, which is most well-known for its Salad Shooter, also manufactures a broad line of slow cookers, griddles, waffle makers, deep fryers, and other small kitchen appliances that can be found at Bed Bath & Beyond and Walmart.  Up until last year, the Housewares segment had been a cash cow for NPK by consistently generating stable profits.

NPK’s Absorbent Products segment sold private label adult incontinence products. Until last year, the Absorbent Products segment had been loss making but because of the relief of some commodity headwinds and the award of some new business from Wall Mart, the Absorbent Products business became profitable. Early this year, NPK sold the absorbent products business at a nice multiple for about $10 per share in value.

The management at Presto is extremely conservative and value oriented. CEO Maryjo Cohen owns 25% of the 7M shares outstanding, and has been with the company since 1976. Maryjo is a third-generation owner and took over the role of CEO from her Father in 1994.  She is an extremely patient and disciplined manager who continues to live In Eau Claire (population 65,000).  As of last year, Cohen still lived in the three-bedroom, poured concrete home she grew up in. According to Forbes, she flies coach, stays at Holiday Inns when traveling and borrows from the library despite being a multi-millionaire.

NPK’s management keeps to itself.  NPK has no sell-side coverage, no conference calls, very little interaction with anyone outside of the company and attends no sell side conferences. Importantly, because of its opacity, NPK’s stock is very slow to react to changes in the fundamentals of the underlying business.  Most of the incremental buying and selling in the name comes from index and quant funds.   To illustrate the interest of active management, the picture below is from last year’s annual meeting.  Most of the people that attended were either affiliated with the company or were former NPK employees.  Because the management does not typicly provide much information on calls with investors, the annual meeting is really the only timewhen they will meaningfuly respond to questions.

When we were originally looking at NPK, the stock was trading in the low $80s with EPS of around $5.50 per share for a multiple of 15X earnings.  The business had low earnings growth and no real sales growth over the last few years.  We became interested in NPK last year when the company announced a significant foreign military supply agreement for its 40mm ammunition. This contract was provided to NPK as a subcontractor for a £100MM contract that UK based Chemring Group received to supply the Iraqi army.

The Chemring Contact was not properly appreciated by the market and would lead to outsized earnings and revenue for the defense segment in late 2016 and early 2017.  An incremental $99MM of revenues represented an additional $21MM of additional operating profit or $2.00 per share in earnings. Given that the defense business typically generates revenue between $200MM and $230MM a year, the Chemring Contract was. The lack of managers active in the stock likely explains its failure to anticipate the additional earnings and revenues from the new order.

The defense segment posted decent growth in sales and earnings in Q3 of 2016, but this was clouded by the Housewares segment which suffered significant declines in profitability and revenue.  Our checks suggested that the Housewares segment was no longer selling into Target stores and was suffering alongside its other customers from the disruptive influence of e-commerce. In Q4, the foreign order on top of a strong Q-4 delivery of 40MM resulted in Defense segment sales expanding over 40% year over year and defense operating profit increasing by over 80%. Defense’s growth in the Q4 was more than enough to compensate for Houseware’s 17% decline in revenue and 22% decline in profitability.  

When we initiated our position in NPK, we believed that quantitative investors would bid up the stock as the company’s GAAP financials reflected increased earnings and revenue from Chemring Contract in the defense segment. This is illustrated by the chart above where NPK’s stock price was stable at the time of the contract’s announcement and did not start to rise until the contract’s new orders were reflected in earnings and sales growth.  Since that time, the stock has risen nearly 50%, from $80 to $120.  The table below illustrates that quantitative and index buyers (with Renaissance Tech. leading the charge) have dominated new share purchases even in Q3 as the qualitative story has deteriorated but is not yet reflected in the GAAP numbers.

Despite the successful outcome, we were surprised by the weakness of the Housewares segment that unfolded over the course of last year.  We also recognized that the Chemring Contact masked a serious decline in NPK’s base business with the US government. Our conversations with industry contacts also made us begin to question whether NPK would successful retain its status as the sole Prime for the 40MM business.  Because of our concerns we sold NPK early in 2017. Nonetheless, we continued to follow NPK incase new information came to light.

From Long to Short

Unfortunately for National Presto this is not an amendment to our bullish thesis.  The exhaustion of last year’s foreign 40mm award is likely to create a serious drag and tough compare starting in Q4 2017.  Based on our conversations with industry contacts and competitors, the result of a FOIA inquiry, the company’s disclosure and our review of government documents we believe that NPK’s monopoly like position as the sole prime contractor for 40MM ammunition is in the process of being eliminated jeopardizing the company’s revenues and that its profits. The company has lost next generation 40mm training round contracts as the military has started to shift away from using a sole sourced provider. Additionally, the Houseware’s business, continues to suffer double digit topline declines. We believe that consolidated revenue and profits are on the verge of turning over, and the stock has the potential to fall 40%-60% over the next six to 18 months.

Housewares Segment in Free Fall

When we first looked at National Presto two years ago, one of the bright spots was the very consistent houseware segment. While the segment never produced tremendous growth, it did provide the company with a stable source of free cash flow generation. This cash flow was reinvested in the higher ROI defense segment. Recently, the small appliance industry has been under tremendous pressure due to the struggles of its end customers such as Bed Bath & Beyond, Target, and JC Penney. What had been a consistent source of cash flow has now turned into a drag, as operating income was negative in the second quarter of this fiscal year. We do not believe these pricing pressure and inventory destocking trends will abated and have a negative outlook for the household product segment.

The Defense Segment: Exhaustion of the Chemring Contract

NPK’s sales of 40MM ammunition is the most important variable that drives its defense business. We believe that 40MM sales are greater than 60% of Defense revenues and more than 70% of Defense profits. As mentioned above, we invested in NPK last year in large part because a large foreign order would cause revenues and profits to inflect. Over the last twelve months revenues have been boosted by the $99MM foreign military supply agreement announced last April.

During the first nine months of 2017, NPK’s defense sales increased by $14,547,000 from $145,599,000 to $160,146,000, or 10%, primarily reflecting an increase in units shipped.  According to Chemring’s latest filing (see below), its order book recently declined because of the completion of its 40MM contract with Iraq.  Chemring previously announced that it had delivered £44MM of the Iraqi order in the second half of last year.  Therefore, roughly 66% of the order was shipped in the first nine months of this year.  That would equal roughly $65MM for NPK.  Absent the Chemring Contract, sales for the defense business in the first nine months of this year would have been about $95MM or down roughly 35% from last year’s $145.6MM.

All things equal, the exhaustion of the Chemring alone will likely create a vacuum in NPK’s 40MM business over the next few quarters.  However, NPK’s problems don’t end with the Chemring contact because the US government has stepped away from NPK being its sole prime contractor for 40MM ammunition.

Defense Segment: The US Government’s Transition Away from NPK as Sole Prime

National Presto received its first five-year 40mm contract from the US government in 2005, and a second in 2010. At the time, there were two “small business” contractors fulfilling the 40mm contract, NPK and DSE.  The US was engaged in fighting the Iraq and Afghanistan wars, and the demand for 40MM rounds to support ground troops was elevated. As the wars in began to wind down, stockpile of tactical 40MM rounds grew and demand shrank. Consequently, both NPK’s and DSE’s revenues declined. DSE also suffered some quality issues that eventually led to its insolvency. DSE’s financial woes forced the US Government to allow NPK to acquire DSE’s backlog. In 2013, NPK acquired DSE and its 40mm backlog related to the 2010 government contract, consolidating the 40mm market into a sole prime contractor.  The US government would prefer multiple suppliers to maintain price competition, reduce the probability of corruption and provide for redundancy of production.

In September of 2014, the Army issued a new RFP for the next 5-year base 40MM contact.  Initially, the Army was looking to split the award among two small business 40-mm producers in order to get away from being confined to NPK as its sole prime.

With less than 1500 employees, NPK is deemed to be a “small business” but other larger companies like General Dynamics or Tech Ord are much too large to qualify.  Other smaller companies did not have the scale or capability to participate. As a result, there were no other bids submitted by qualified producers during the 2014 solicitation. Eventually, the army canceled the solicitation for the 2015 to 2019 award. To meet its needs in the short term, the government awarded NPK a one-year contract for $84.5MM for 2016.  Much of the ordinance was for a further supplement for the Iraqi military to fight ISIS and it was due to be principally exhausted in 2017.

After the failure of the 2014 solicitation for the next 5-year contract, the Army was frustrated with its lack of options.  Initially, to address the issue, the Army decided to split the five-year base contact award and open-up the bidding for the creation of the next generation of 40MM training rounds and eliminate the requirement that bidders qualify as small businesses. The government was seeking lower cost rounds that could be used at night.  This was an important step because much of what had been supplied to the US government over the last several years were 40MM training rounds. NPK qualified to build prototypes to compete for both of the next generation high velocity and low velocity training round awards. The low velocity rounds are for individual firing with weapons like the M320 grenade launcher (see above), while the high velocity rounds are used in crew-served weapons such as the Mk19 Grenade Machine Gun (see below). American Ordnance qualified to build a prototype to compete for the high velocity training round contract and General Dynamics qualified to compete for the low velocity training round contact.

When it came time to initiate the new bidding process in 2016 for the next five-year base, there was an extensive list of competitors who participated. Based on a FOIA request we obtained, we know that there were over 20 participants involved (see Appendix A). Moreover, the long-standing tradition of giving favor to small business participants was abandoned in favor of price and manufacturing capabilities (see highlights in Evaluation Criteria above). Abandoning the small-business initiative eliminated one of National Presto’s primary competitive advantages relative to other larger bidders like Chemring, Orbital ATK and General Dynamics.

To make matters worse, the projected amount under the new 5-year contract was substantially lower than the previous two 5-year awards. A large portion of the previous awards had included training rounds. This can be seen based on the $84.5M one year stop gap award that was secured by NPK last year.  The highlighted training rounds included in the 2016 order (see across) represented 83% of the total units awarded last year.

NPK did eventually win new 5-year award.  However, when DOD announced the 5-year NPK award it also announced the award to General Dynamics for the low velocity training rounds and American Ordnance LLC for the high velocity training rounds.

The base contacts with all possible options for the two new training contracts are worth a total of $395M and $145M, respectively.  On the other hand, the new 5-year award given to NPK was only for $77.7M, consisting mainly of live ordinance. There may be supplemental awards given relating to the new 5-year base award, but without a ground war, it is clear that bulk of 40MM unit sales will now be made to General Dynamics and American Ordinance for training rounds. To provide some perspective, the amounts budgeted to be spent on the training projects awarded to American Ordinance and General Dynamics equal in total $540M.  The total amount spent on live ordinance and training rounds in the 2010 to 2015 award (when we still had higher engagement in Afghanistan) totaled $754M.  In other words, it is likely NPK’s defense revenues will be under pressure for years to come.

In addition to losing the new contract, NPK has been effectively designed out of all future training round contracts. We have learned from industry contacts that in the past, one of NPK’s major competitive advantages was that it was the only company that could make the fuses associated with 40MM ammunition. However, the new generation of training rounds do not contain this fuse, and instead use a combination of plastic and material, which when dispersed with air and creates a flash. Based on our industry contracts, we understand that these projectile bodies are proprietary to General Dynamics and American Ordnance, effectively boxing out National Presto.

Despite NPK winning the next 5-year award, in September of 2017, the Army initiated a new solicitation for the next generation of ballistic ammunition that can be used for high velocity weapons like the MK 19. Orbital ATK has already developed programable air-bursting munitions and has demonstrated their use. NPK has avoided electronic fuse development and has focused only on mechanical fuses. This will likely mean that NPK may not only have to live without the 40MM business for training rounds but they will also likely give up share to the programable air-bursting ballistic munitions.

Projected Decrease in Total 40MM Round Procurement for 2018 vs. 2017

The story gets worse.  The government is currently projecting procurement of 40mm rounds will decrease in 2018 versus 2017. Our discussions with industry participants indicate that there is a large surplus of tactical (live) 40mm inventory. Therefore, based on the available data provided by the Office of the Under Secretary of Defense (Comptroller), the government is projecting the total procurement level (tactical and training) of 40mm rounds to fall from $118.8 million in 2017 to $108.2 for 2018 (See tables below).

Conclusion

The financial impact of the above dynamics within the two segments is relatively straight-forward. We are expect both revenue and earnings to decline beginning in 2018. On a trailing twelve months basis the company has generated $6.72 in EPS, a figure we expect to fall to between $3.00-$4.50 in 2018. With declining revenue and earnings, we believe the market will likely place a more conservative multiple on the operating earnings, somewhere around 10x EPS plus the company’s net cash of $18 per share. This would indicate fair value of $48 to $63 per share, or roughly about 45% to 60% downside. Alternatively, we also value the company on a sum-of-the-parts basis. In this scenario we use a 1x revenue multiple for the household products business, and 10x free cash flow for the defense segment. Adding the $18 per share of cash on the balance sheet yields a fair value of $64 per share, or 45% lower. Should the top-line at either business segment deteriorate at an accelerated pace, or if fixed-cost deleveraging amplifies the effect to the bottom-line, we believe EPS could fall further than we are currently projecting and thus the fair value of the company would be lower.

Risks

• The primary risk is a strategic buyer acquires the defense business. While possible, given the new competitive paradigm relative to the next-generation rounds, we believe the probability of such a take-out is low. If we use the Orbital ATK acquisition by Northrup Grumman as a potential proxy at 1.65X sales the comparable purchase price would be $58 per share.  Assuming the housewares business is worth 1X sales or $14.50 a share the sum of the parts would be about $90.50 per share or roughly 30% lower than today’s price $117.

• National Presto makes a high-ROI acquisition. This is a possibility, given the company has $127M of cash and no debt. However, National Presto has historically been very conservative with its capital, and we believe it is unlikely the company reaches for a pricy acquisition. Maryjo Cohen owns a significant amount of the company, so it would make little sense for the company to make an acquisition just for show, as we have seen other companies do recently. She is extremely conservative and is focused on value.  The company has communicated to us that there is little that they currently find attractive in today’s market.

• War! Should the US enter into a new ground conflict, the procurement of tactical 40mm rounds could increase. This would benefit National Presto’s defense segment.

• Go Private? With interest rates low and MaryJo Cohen being the only heir to the throne, it’s possible she could take this company private through some sort of transaction (JV, etc.). The company has $127M of cash and no debt, and there would be few impediments given Ms. Cohen’s substantial ownership. However, we think this too is unlikely given Cohen’s very conservative nature. At least as far back as 1991 NPK has maintained a  substantial net cash position.

• NPK issues a special dividend. NPK has about $18 in cash on its balance sheet.  Without desirable investment candidates, NPK could elect to issue a special dividend.

Additional Disclosure: This information is provided for informational purposes only. This information is not complete and is only current as of the date hereof and may be superseded by subsequent market events or for other reasons. This information is not investment advice and is not a recommendation to purchase or sell any specific security. The author does not make any representations or warranties as to the accuracy or completeness of the information. The author has a position in the security presented, which may be increased or decreased at any time with no notice to the recipient of this information.   This presentation contains forward-looking statements that include statements, express or implied, regarding current expectations, estimates, projections, opinions, and beliefs of the author, as well as assumptions on which those statements are based. Words such as “believes,” “expects,” “endeavors,” “anticipates,” “intends,” “plans,” “estimates,” “projects,” “assumes,” “potential,” “should,” and “objective,” and variations of such words and similar words, also identify forward-looking statements. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, including those described in this presentation, and accordingly, actual results may differ materially and no assurance can be given that the security presented will achieve the results discussed herein. Recipients are cautioned not to place undue reliance on any forward-looking statements or examples included in this presentation, and the author assumes no obligation to update any statements as a result of new information, subsequent events or any other circumstances. Such statements speak only as of the date that they were originally made. Please do your own due diligence.     

Appendix A

(Roster for 2016 40MM Systems Industry Day FY-17-21)

Catalyst

* Sales and profits drop over the next few quarters as NPK laps its completed Forigen Order which likely was resposible for more than $60MM of sales over the last nine moths.

* Sales and Profits for the Defense business fall as the US government diverts 40MM training round purchases to General Dynamics and American Ordinance. 

* The Housewares business continues to deteriorate.