Description

Business Description:

Nacco Industries (“NC”) is a diversified manufacturing company operating in three divisions: Materials Handling, Housewares, and Coal. All three divisions are undergoing certain changes to grow and meaningfully increase operating margins. NC is currently trading at approximately $144/sh. We believe that earnings in the next couple of years can approach $30/sh -$35/sh as manufacturing initiatives and new product introductions unfold. This would be a significant improvement from approximately $7.60/sh in 2005.

Materials Handling is the largest segment, representing approximately 45% of 2005 operating income and has the most upside opportunity. This division manufactures and markets lift trucks (fork lifts) under the Hyster and Yale brands. Materials Handling is a top-four lift manufacturer worldwide. In 2005 the division posted an operating margin of about 2.5% as it had difficulty keeping-up with the increase in steel prices - an issue that management believes they have finally tackled. However, the company will not fully benefit from this until 2007. Historically, this division has operated between -2.6% and +7.5% EBIT margins. Recent product introductions and manufacturing improvements should send this margin meaningfully higher in the near-to-medium term.

Housewares is the second largest segment with approximately 35% of the 2005 operating income. This division makes kitchen products under the Proctor/Silex and Hamilton Beach brands. The division also owns the Kitchen Collection chain of retail stores. Historically, the division has operated with margins in the high single digits, and is currently running at 6%.

The final segment is the North American Coal Company. This is not a typical coal company, in that it is not subject to price fluctuations of coal. The type of coal produced (lignite), is very low quality and is so cheap that it does not make sense to transport the coal any great distances. Instead, power plants are built on the mine site, with exclusive contracts signed for long-term coal deliver. The contracts are basically a cost-plus agreement, with cost adjustments made annually. NC describes their coal business as an outsourced mining operation, which happens to own a significant portion of the reserves it mines. The division also mines limerock in Florida for companies without any mining expertise. The coal division typically operates with a low teens operating margin, however, this has been recently impacted by the cost of raw materials. While the division is on a cost plus basis, the nature of the contracts results in a few years for spikes in raw materials to be completely reflected in the pricing.

Opportunity:

The majority of the forecasted earnings improvement is coming through the Materials Handling group. In 2005, Yale and Hyster began to revamp their product lines. Both brands released the Fortis line of lift trucks. The new line is in staggered release through the end of 2007, and encompasses about 50% of the Hyster/Yale lines. While new lifts are generally released quite often, the lift truck industry generally has very little innovation. Occasionally, a truck might add a few new features, but meaningful improvements only happen over decades. The Fortis line is different. This truck has a computer controlled transmission (never been done before), has a new engine (engines rarely change), and has a number of other value-added features. The most important feature is that the new models effectively limit transmission damage, resulting in lower maintenance expenses and longer lift life. Given these features and the value to the end-user NC is likely to push through a meaningful price increase over existing models. As NC has revamped its product line it has ceded share to its competitors in the last 1-2 years. NC expects to be able to recapture and then gain market share with these new products which currently have no competition on the added features. Our checks have indicated that Toyota was planning on releasing a new truck at the same time as the Fortis. As a testament to the innovation of this truck, Toyota has pulled the launch of its new truck to try to incorporate many of the new features in the Fortis. Toyota appears to be about 2 to 3 years away from launching a comparable truck, giving NC a very nice first mover advantage. Combined with revamped manufacturing NC believes that they can get EBIT margins in Materials Handling to 9% in a normal lift market. (Current market forecasts for lifts worldwide are benign over next few years). Important to note is that the 9% margin is predicated on the 2005 sales level. We believe that by the time the company actually sees the full effects of the product launch it will be on a meaningfully higher sales base and operating leverage can take that margin even higher.

The Housewares division has had some recent problems with its retail business. Same store sales have been hurt by poor merchandising and lower foot traffic. The response has been to completely revamp the merchandise line, and close underperforming stores. In addition, the Housewares group has restructured its manufacturing process to drive incremental savings. The net result is that the Housewares segment should be able to deliver 9% margins by 2008. While the new merchandising strategy is part of this drive for higher margins, the majority of the margin improvement is coming from the restructured manufacturing.

Finally, the Coal division has suffered due to higher raw materials prices. While the group operates on a cost-plus basis, it does have to absorb these higher prices in the short-term. Annual price adjustments are based on an index of prices using trailing average commodity costs. As a result, it will be several years before these commodity prices are fully absorbed by the customers. In addition, should these prices fall, the division would be able to benefit from the lower costs in a similar manner. The net result is the division should be able to return to its low teens margins. Secondly, the division has been growing its limerock operations in the past several years. Limerock deliveries have more than doubled in the past three years, and will continue to grow for at least 2 more years as new operations are brought online.

In NC’s 2005 annual report the company actually lays out the earnings benefit from the Materials Handling and Housewares improvements. Based on 9% for each division (on the 2005 sales) earnings would have been approximately $22/sh. We believe that this materially underestimates the actual earnings the company will report when it hits its goals. The lift market is forecasted to grow from 2005 at least through 2008. This market growth coupled with market share gains and the new product price improvements, will likely result not only in the margin being higher than 9% but also a meaningfully higher sales base than 2005 for Materials Handling. Throw in some debt repayment and we believe that EPS in the low-mid $30s/sh by 2008 is achievable.

Miscellaneous:

One might ask why sell-side analysts have not picked-up on these improvements. The answer is simple – no one covers it.

For those that see separating the companies as a nice catalyst – don’t count on it. The founding family controls the company and I get the sense that they like the collection of assets they currently have. On the plus side – the family has significant skin in the game (about 25% of the shares outstanding) which is nice to see given the current financial leverage. Compensation is reasonable. They don’t issue options to themselves, preferring to use restricted stock.

Currently, the company has more debt than we or the company would like. EBIT/interest coverage for 2005 was approximately 2.8x (p.f. for 2Q06 debt refinancing). This metric should improve meaningfully over the course of 2006. EBTIDA/p.f. interest for 2005 was 4.3x and the company has cash on the balance sheet for approximately 2 years worth of capex. Furthermore, their markets are currently healthy and NC should generate meaningfully cash flow over next couple of years. Recent refinancing gives us some comfort that banks are not concerned.

Risks:

The new lifts are not as well received as our research indicates.
Lift market goes into the tank before the benefits of the new products can manifest themselves.

Disclosure:

We and our affiliates own shares of NC, and may buy additional shares or sell some or all of our shares, at any time without notice. We undertake no obligation to update information provided above or to inform you of any changes in our views of NC. This is not a recommendation to buy or sell shares.

Catalyst

Earnings potential coming to fruition.
Company indicates that they would like to get the story out there – but who knows.