National Presto Industries, Inc NPK S
April 27, 2010 - 1:15pm EST by
mikeperry22
2010 2011
Price: 115.50 EPS $9.13 $7.00
Shares Out. (in M): 7 P/E 12.7x 16.5x
Market Cap (in $M): 792 P/FCF 12.5x 16.5x
Net Debt (in $M): -167 EBIT 91 70
TEV ($): 624 TEV/EBIT 7.0x 9.0x
Borrow Cost: NA

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Description

Business Summary and History
1. National Presto Industries (NPK) is a conglomeration of three distinct businesses:  Housewares / Small appliances, Defense products, and Absorbent products  
2. Over the last 100+ years it has been a kitchen appliance and ammunition manufacturer.  It made several timely acquisitions in the ammunition segment in 2003 and 2006, as well as an acquisition of a diapers business in 2001 and 2003
3. For a more detailed history, visit the website: http://www.gopresto.com/information/history.php

Segment Summaries
1. Small Kitchen Appliances
    a. $150M in sales in 2009, or 31% of total, $30M EBIT in 2009, or 33% of total
    b. This business sells small kitchen appliances in the US at the value price point.  These appliances are sold under the Presto brand through various retailers.  Approximately 35% of sales for this segment are to Wal-mart
    c. North American market for small appliances is approximately $4B.  Jarden (JAH) is the largest player with approximately 30% market share.  Other large players are Conair, Whirlpool, Phillips and Braun
    d. Nearly all products in the market are manufactured in China
    e. Products are sold to retailers and distributors in the US and Canada and the company has no long term supply contracts
    f. For pictures of the various Presto branded small kitchen appliances, see the website:  http://www.gopresto.com/recipes/index.php  
2. Defense products
    a. $254M in 2009 sales, or 53% of total, $55M EBIT in 2009 or 60% of total
    b. Business primarily manufactures 40mm ammunition for sale to the military
    c. Presto in 2005 / 2006 won a 5 year contract to supply 40mm for the military.  They have delivered approximately $500M in ammunition under this government contract over the last 5 years.  
    d. Revenue from US military accounted for over 50% of sales for this segment during the last several years
3. Absorbent Products
    a. $75M in 2009 sales, or 16% of total, $6M EBIT in 2009 or 7% of total
    b. Purchased in 2001 from Rmed International, a company that manufactured private label diapers.  In 2003, company purchased assets of NCN Hygenic Products, a private label manufacturer of adult incontinence products and pads for dogs
    c. Products are sold through brokers and distributors into highly competitive markets

Short Thesis
1. Expect significant margin contraction from the peak levels of 2009 in all three business segments to more sustainable long-term levels
    a. Small appliance - Margins were 20% last year - vs average of 16% from 2003 to 2008 because, as with many consumer goods manufacturers who experienced dramatic input cost inflation in 2008, they were able to pass on price increases, and held price up even as input costs collapsed in 2009
        i. I believe that they are getting squeezed on both sides now - feeling both pricing pressure from their customer base, and also feeling upwards pressure on input costs but even if I am only right on one of these two occurring margins should come down
            1. WMT is the biggest customer with 35% share and has been rolling back prices on a number of different categories.  Given that Presto fits the value price-point segment and no new pricing power they have little pricing power
            2. Input costs rising.  COGs for this segment are:
                a. ~20% Chinese labor
                    i.  Most of the small appliances in the world are manufactured in China, and in particular the Guongdong province.  While I do not profess to be a China expert, the Guongdong province has been experiencing major labor shortages in recent months and in fact just recently raised its minimum wage by 20%.  NPK is a relatively small manufacturer and so they should be a price taker of labor
                    ii. Confirmed from several manufacturers that Chinese labor is becoming an issue
                b. ~70% raw materials
                    i.  Comprised of steel, aluminum, plastic, and to a lesser extent, copper
                    ii. Costs of each of these components are up 50%+ from 2009 lows
                    iii.Company does not hedge commodity costs
                c. ~10% freight
                    i. Sources indicate that freight from China us up 50% or more from 2009 lows
                    ii.Verified from multiple sources that 20%+ EBIT margins are not sustainable for a small appliance manufacturer.  In particular one with small market share and no new discernable products like NPK
    b. Defense - Margins were 22% in 2009 vs 17% average from 2003 to 2008 because of collapsing steel, aluminum and oil costs
        i.  Though the company does not disclose it, based on the documentation I've found in the 40mm ammo RFP from the military, I believe that the company absorbs any commodity movement + / - 3% of the price of the product
        ii. In addition the company fully absorbs the cost of all other non-steel and aluminum prices per the army RFP documentation.  These could include prices of transport, electricity, packaging etc, which all fell in 2009 but are now rising
    c. Absorbent Products - Margins were 8% last year vs. average of -5% from 2003 to 2008 because of collapsing pulp costs
        i.  This sub-scale, commodity business segment was loss-making every year until 2009, when the margins exploded upwards for a couple quarters, similar to what I've observed for many other companies relying on paper / pulp as an input costs
        ii. KMB's earnings call last week confirmed that rising pulp prices were impacting margins
        iii.By Q4 2009 the margins had already started falling precipitously  to 5% after spiking to 14% in Q3
        iv. I anticipate this trend to continue and potentially return to pre-2009 loss-making levels  
2. Defense segment faces potential for significant topline decline due to military budget cuts for 40mm ammunition
    a. As stated earlier, the defense segment generated over 50% of its revenue over the last 5 years from a military contract to manufacture 40mm ammunition
    b. The FY 2010 and FY 2011 military procurement budget point to a sharp decline in purchases of 40mm ammunition by the military
        i.  2009 budget was $318M, 2010 budget is $176M, 2011 budget is $230M
        ii. Budgeted decline appears specific to 40mm ammunition, as the total ammunition budget is not down significantly
        iii.Numbers can be viewed here on pages A-14 of the FY 2011 DOD Procurement Budget:  http://comptroller.defense.gov/defbudget/fy2011/fy2011_p1.pdf
    c. Company reported backlog of $274MM in this segment at the end of 2009, up from $265MM at the end of 2008
        i.  10-K indicates that most backlog should be recognized as revenue in the next 12 to 14 months, which historically as been the case
        ii. The backlog number appears inconsistent with the military's budgeted 40MM ammunition number for FY 2010, which began on 10/01/09
        iii.Three possible explanations
            1. Ammunition manufactured by NPK lags the budget cycle by up to a year
            2. Company has found another large purchaser of 40MM ammo to replace the sales reduction forecast by the DOD's budget
            3. Company is aggressive in its backlog accounting
        iv. I don't believe it likely that the company has found another buyer of its 40mm ammunition to replace the orders lost from the US government budget falling by almost 50% -- therefore I believe it is likely that revenue in this segment will fall at some point over the next 12 to 18 months

What's it worth?
1. 2009 earnings of $9.13 most likely marked the peak in earnings for NPK, and over the next 1 to 2 years I believe they will trend meaningfully lower
    a. While no analysts cover the stock, I believe that the quant computers who have driven the stock to all-time highs in recent months are expecting 2010 earnings to be in the $10 to $11 range  
    b. Earnings and ultimate valuation depend on whether or not military orders of the 40mm ammunition fall, but I think it is a good short in either case on the likely margin compression it will experience
    c. At the current $116 stock price it is between 10x and 11x what I think the owners expect the earnings to be when deducting the ~$16 per share cash balance
        i. Note the company paid a $7 special dividend in March and so the cash balance is lower than the initial inspection might indicate.  
    d. I calculate normalized earnings at $6 to $7.50 assuming margins return to historically average levels, and assuming 40mm sales to the government continue to grow in line with backlog.  I think that this collection of weak/mediocre businesses should trade at 8x and 10x earnings, leading to a target price range between $65 and $90 (adding back the cash).  
    e. If the revenues in the military segment fall off I think the Company can achieve $3 to $6 in earnings and the stock settles in the $40 to $70 range using a similar multiple range
    f. In either case, at $116 it makes for a fairly compelling short with somewhere between 20% and 60% upside

Risks
1. Biggest risk is being wrong that margins are coming down across all of the segments
    a. This is mitigated by the fact that earnings should disappoint the quant models if margins are down in any segment.  I think margins will come down in at least one or more of the segments for the reasons above
    b. In addition I think the risks to this not actually happening is reduced by statements by the company indicated that margins will indeed contract
        i. In its year end press release, the Company hinted at this rather poetically, while at the same time taking a shot at the Fed and Congress:
            1. "A sizable portion of the improved profitability for all three Segments admittedly stemmed from reduced commodity costs that were directly attributable to the weak economy, proving the truth of the J.R.R. Tolkien adage that 'it's an ill wind as blows nobody no good.'"
            2. "The combination of the Federal Reserve's ultra easy money policy and Congressional fiscal irresponsibility is a classic recipe for inflation. Commodity and freight costs have been rising steadily since the later part of 2009 and could very well return to the inflated levels of 2008. Increased costs would have a deleterious effect on all three businesses, particularly Housewares/Small Appliance and Absorbent Products, which unlike Defense, do not have sizable backlogs that enable the locking in of pricing in advance. Nonetheless, the Company has survived similar challenges in the past. Its strengths - a cadre of talented, dedicated, and experienced personnel along with its strong balance sheet - place it in an enviable position vis a vis its peers."
            3. Putting aside the fact that I happen to agree with them on the political and economic issues that this country faces, I think this another solid piece of evidence that the Company's 2009 margins were abnormally high
        ii. Though the Company seems fairly forthright that 2009 margins are unsustainable, I do not believe many owners of the stock have read these press releases or filings which is the likely reason why the inefficiency exists
2. Timing is another risk
    a. If the company meets expectations this quarter it will validate the long thesis and there the potential for a multiple rerating  
    b. This cycle has been particularly brutal to shorts who have been off by as little as a quarter on the margin miss thesis as quant longs use this validation that record margins and ROICs are sustainable and drive the stock to ever-higher multiples and I would expect NPK to be no different
        i. Believe we are getting close to the tipping point for NPK and many of these similarly themed shorts, as I model earnings down year over year in Q1 for NPK for the first time in 15 quarters
    c. If the stock becomes heavily shorted and the quarter turns out to be ok, there is the potential for a short squeeze to compound the quant longs piling on.  I would take this as an opportunity to add to my position, assuming nothing has happened to change the thesis
        i. Believe that many of the holders will sell in a fairly binary fashion if the earnings roll over, reducing the risk from high short interest

 

Catalyst

 
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    Description

    Business Summary and History
    1. National Presto Industries (NPK) is a conglomeration of three distinct businesses:  Housewares / Small appliances, Defense products, and Absorbent products  
    2. Over the last 100+ years it has been a kitchen appliance and ammunition manufacturer.  It made several timely acquisitions in the ammunition segment in 2003 and 2006, as well as an acquisition of a diapers business in 2001 and 2003
    3. For a more detailed history, visit the website: http://www.gopresto.com/information/history.php

    Segment Summaries
    1. Small Kitchen Appliances
        a. $150M in sales in 2009, or 31% of total, $30M EBIT in 2009, or 33% of total
        b. This business sells small kitchen appliances in the US at the value price point.  These appliances are sold under the Presto brand through various retailers.  Approximately 35% of sales for this segment are to Wal-mart
        c. North American market for small appliances is approximately $4B.  Jarden (JAH) is the largest player with approximately 30% market share.  Other large players are Conair, Whirlpool, Phillips and Braun
        d. Nearly all products in the market are manufactured in China
        e. Products are sold to retailers and distributors in the US and Canada and the company has no long term supply contracts
        f. For pictures of the various Presto branded small kitchen appliances, see the website:  http://www.gopresto.com/recipes/index.php  
    2. Defense products
        a. $254M in 2009 sales, or 53% of total, $55M EBIT in 2009 or 60% of total
        b. Business primarily manufactures 40mm ammunition for sale to the military
        c. Presto in 2005 / 2006 won a 5 year contract to supply 40mm for the military.  They have delivered approximately $500M in ammunition under this government contract over the last 5 years.  
        d. Revenue from US military accounted for over 50% of sales for this segment during the last several years
    3. Absorbent Products
        a. $75M in 2009 sales, or 16% of total, $6M EBIT in 2009 or 7% of total
        b. Purchased in 2001 from Rmed International, a company that manufactured private label diapers.  In 2003, company purchased assets of NCN Hygenic Products, a private label manufacturer of adult incontinence products and pads for dogs
        c. Products are sold through brokers and distributors into highly competitive markets

    Short Thesis
    1. Expect significant margin contraction from the peak levels of 2009 in all three business segments to more sustainable long-term levels
        a. Small appliance - Margins were 20% last year - vs average of 16% from 2003 to 2008 because, as with many consumer goods manufacturers who experienced dramatic input cost inflation in 2008, they were able to pass on price increases, and held price up even as input costs collapsed in 2009
            i. I believe that they are getting squeezed on both sides now - feeling both pricing pressure from their customer base, and also feeling upwards pressure on input costs but even if I am only right on one of these two occurring margins should come down
                1. WMT is the biggest customer with 35% share and has been rolling back prices on a number of different categories.  Given that Presto fits the value price-point segment and no new pricing power they have little pricing power
                2. Input costs rising.  COGs for this segment are:
                    a. ~20% Chinese labor
                        i.  Most of the small appliances in the world are manufactured in China, and in particular the Guongdong province.  While I do not profess to be a China expert, the Guongdong province has been experiencing major labor shortages in recent months and in fact just recently raised its minimum wage by 20%.  NPK is a relatively small manufacturer and so they should be a price taker of labor
                        ii. Confirmed from several manufacturers that Chinese labor is becoming an issue
                    b. ~70% raw materials
                        i.  Comprised of steel, aluminum, plastic, and to a lesser extent, copper
                        ii. Costs of each of these components are up 50%+ from 2009 lows
                        iii.Company does not hedge commodity costs
                    c. ~10% freight
                        i. Sources indicate that freight from China us up 50% or more from 2009 lows
                        ii.Verified from multiple sources that 20%+ EBIT margins are not sustainable for a small appliance manufacturer.  In particular one with small market share and no new discernable products like NPK
        b. Defense - Margins were 22% in 2009 vs 17% average from 2003 to 2008 because of collapsing steel, aluminum and oil costs
            i.  Though the company does not disclose it, based on the documentation I've found in the 40mm ammo RFP from the military, I believe that the company absorbs any commodity movement + / - 3% of the price of the product
            ii. In addition the company fully absorbs the cost of all other non-steel and aluminum prices per the army RFP documentation.  These could include prices of transport, electricity, packaging etc, which all fell in 2009 but are now rising
        c. Absorbent Products - Margins were 8% last year vs. average of -5% from 2003 to 2008 because of collapsing pulp costs
            i.  This sub-scale, commodity business segment was loss-making every year until 2009, when the margins exploded upwards for a couple quarters, similar to what I've observed for many other companies relying on paper / pulp as an input costs
            ii. KMB's earnings call last week confirmed that rising pulp prices were impacting margins
            iii.By Q4 2009 the margins had already started falling precipitously  to 5% after spiking to 14% in Q3
            iv. I anticipate this trend to continue and potentially return to pre-2009 loss-making levels  
    2. Defense segment faces potential for significant topline decline due to military budget cuts for 40mm ammunition
        a. As stated earlier, the defense segment generated over 50% of its revenue over the last 5 years from a military contract to manufacture 40mm ammunition
        b. The FY 2010 and FY 2011 military procurement budget point to a sharp decline in purchases of 40mm ammunition by the military
            i.  2009 budget was $318M, 2010 budget is $176M, 2011 budget is $230M
            ii. Budgeted decline appears specific to 40mm ammunition, as the total ammunition budget is not down significantly
            iii.Numbers can be viewed here on pages A-14 of the FY 2011 DOD Procurement Budget:  http://comptroller.defense.gov/defbudget/fy2011/fy2011_p1.pdf
        c. Company reported backlog of $274MM in this segment at the end of 2009, up from $265MM at the end of 2008
            i.  10-K indicates that most backlog should be recognized as revenue in the next 12 to 14 months, which historically as been the case
            ii. The backlog number appears inconsistent with the military's budgeted 40MM ammunition number for FY 2010, which began on 10/01/09
            iii.Three possible explanations
                1. Ammunition manufactured by NPK lags the budget cycle by up to a year
                2. Company has found another large purchaser of 40MM ammo to replace the sales reduction forecast by the DOD's budget
                3. Company is aggressive in its backlog accounting
            iv. I don't believe it likely that the company has found another buyer of its 40mm ammunition to replace the orders lost from the US government budget falling by almost 50% -- therefore I believe it is likely that revenue in this segment will fall at some point over the next 12 to 18 months

    What's it worth?
    1. 2009 earnings of $9.13 most likely marked the peak in earnings for NPK, and over the next 1 to 2 years I believe they will trend meaningfully lower
        a. While no analysts cover the stock, I believe that the quant computers who have driven the stock to all-time highs in recent months are expecting 2010 earnings to be in the $10 to $11 range  
        b. Earnings and ultimate valuation depend on whether or not military orders of the 40mm ammunition fall, but I think it is a good short in either case on the likely margin compression it will experience
        c. At the current $116 stock price it is between 10x and 11x what I think the owners expect the earnings to be when deducting the ~$16 per share cash balance
            i. Note the company paid a $7 special dividend in March and so the cash balance is lower than the initial inspection might indicate.  
        d. I calculate normalized earnings at $6 to $7.50 assuming margins return to historically average levels, and assuming 40mm sales to the government continue to grow in line with backlog.  I think that this collection of weak/mediocre businesses should trade at 8x and 10x earnings, leading to a target price range between $65 and $90 (adding back the cash).  
        e. If the revenues in the military segment fall off I think the Company can achieve $3 to $6 in earnings and the stock settles in the $40 to $70 range using a similar multiple range
        f. In either case, at $116 it makes for a fairly compelling short with somewhere between 20% and 60% upside

    Risks
    1. Biggest risk is being wrong that margins are coming down across all of the segments
        a. This is mitigated by the fact that earnings should disappoint the quant models if margins are down in any segment.  I think margins will come down in at least one or more of the segments for the reasons above
        b. In addition I think the risks to this not actually happening is reduced by statements by the company indicated that margins will indeed contract
            i. In its year end press release, the Company hinted at this rather poetically, while at the same time taking a shot at the Fed and Congress:
                1. "A sizable portion of the improved profitability for all three Segments admittedly stemmed from reduced commodity costs that were directly attributable to the weak economy, proving the truth of the J.R.R. Tolkien adage that 'it's an ill wind as blows nobody no good.'"
                2. "The combination of the Federal Reserve's ultra easy money policy and Congressional fiscal irresponsibility is a classic recipe for inflation. Commodity and freight costs have been rising steadily since the later part of 2009 and could very well return to the inflated levels of 2008. Increased costs would have a deleterious effect on all three businesses, particularly Housewares/Small Appliance and Absorbent Products, which unlike Defense, do not have sizable backlogs that enable the locking in of pricing in advance. Nonetheless, the Company has survived similar challenges in the past. Its strengths - a cadre of talented, dedicated, and experienced personnel along with its strong balance sheet - place it in an enviable position vis a vis its peers."
                3. Putting aside the fact that I happen to agree with them on the political and economic issues that this country faces, I think this another solid piece of evidence that the Company's 2009 margins were abnormally high
            ii. Though the Company seems fairly forthright that 2009 margins are unsustainable, I do not believe many owners of the stock have read these press releases or filings which is the likely reason why the inefficiency exists
    2. Timing is another risk
        a. If the company meets expectations this quarter it will validate the long thesis and there the potential for a multiple rerating  
        b. This cycle has been particularly brutal to shorts who have been off by as little as a quarter on the margin miss thesis as quant longs use this validation that record margins and ROICs are sustainable and drive the stock to ever-higher multiples and I would expect NPK to be no different
            i. Believe we are getting close to the tipping point for NPK and many of these similarly themed shorts, as I model earnings down year over year in Q1 for NPK for the first time in 15 quarters
        c. If the stock becomes heavily shorted and the quarter turns out to be ok, there is the potential for a short squeeze to compound the quant longs piling on.  I would take this as an opportunity to add to my position, assuming nothing has happened to change the thesis
            i. Believe that many of the holders will sell in a fairly binary fashion if the earnings roll over, reducing the risk from high short interest

     

    Catalyst

     
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