Description

At first glance, Reinhold Industries, trading at 9x LTM earnings, doesn’t scream bargain. However, when you peel back the onion on this company, all the insider buying begins to make sense. The investment thesis here includes: Double digit returns on capital, a historical 20% growth rate that is likely to increase going forward given the company’s increased defense industry exposure, insider buying, no debt, no Wall Street coverage, savvy management, a 49% private equity firm shareholder that is motivated to seek a value realization event, significant NOL carry forwards, and an announced $13mm military contract that is worth much more.

Reinhold Industries was formerly a division of Keene Corporation which was a victim of Asbestos litigation and went bankrupt in 1993. The entire history of the company (founded in 1928) is laid out nicely in the 10-K so I will not repeat it all here. In 1999, the private equity firm of Hammond, Kennedy, Whitney, & Company (HKW), who knew the management team well, along with Mass Mutual bought a 49% stake of the company from a Creditor’s Trust that was set up to administer Keene’s asbestos claims. It is my understanding that at the time, the company was basically in stand still position with very little capex was going into the business. The only outstanding litigation concerns arising from Reinhold’s past history involved environmental liabilities from one particular site that was settled for 500k in December of 2002. There is no potential asbestos liability.

The company today operates five different divisions whose financials and descriptions are briefly described below. Remember, the company has no long term debt (had $9mm in 2000), $16mm in net working capital, and a market cap of $65mm.

9 months ended:
Net Sales ($mm): 2003 2002
Aerospace 16.3 12.9
NP Aerospace 14.5 8.3
CompositAir 4.0 4.9
Commercial 2.6 2.0
Bingham 12.5 12.6

Total Sales 49.9 40.8

9 months ended:
Pretax Income ($mm): 2003 2002
Aerospace 5.2 4.3
NP Aerospace 3.2 0.8
CompositAir 0.3 0.2
Commercial 0.0 0.1
Bingham (0.6) (0.4)
Other (0.7) (1.5)

Total Pretax Income 7.2 3.5

Aerospace – This division manufactures composite components mainly for subcontractors of the U.S. defense industry. This is the gem division of the company as the margins are good and the growth going forward should be strong. During 2002, sales increased 87% in this division because Reinhold was awarded a $13mm contract for components related to the Air Force’s Minuteman III Propulsion Replacement Program which Reinhold has been part of since the first program begin in 1960. The contract was awarded to Reinhold from Alliant Techsystems (ATK). Tucked away in an old press release is the fact that this contract could be worth $80mm through 2007, if the Air Force elects full rate production. The company has told me that that this is annual purchase order and that they “continue to expect this order.”

NP Aerospace – This division operates out of Coventry, England and operates in niche marketplaces for the sale of commercial aircraft seatbacks, helmets, and light armored vehicles. Sales increased 43% in 2002 due to higher shipments of body armor and military helmets and have increased 74% through 2003.

Bingham – This was the result of one of two add on acquisitions that HKW helped the company engineer. It was acquired in 2000 in a private transaction. Bingham manufactures, sells and distributes composite component products through 9 locations in the United States and Canada. This acquisition has been a disappointment to the company and they are trying to turn it around.

The other add on acquisition was Edler Industries, Inc. which also was acquired in a private transaction in 2001. Edler is a manufacturer of structural and ablative composite components mainly for prime contractors and subcontractors of the U.S. defense industry. Unlike Bingham, this acquisition has been successful and has been incorporated into the Aerospace division.

The other divisions are not central to the investment thesis here and will not be broken out.

Below is a snapshot of the company’s financials highlighting 1998, 2002, and YTD results.

Sales have grown at an annualized rate of 22%, net income at 19%, and the backlog at 21%. While part of this growth was achieved through acquisitions (funded by debt), the company today has entirely paid down their debt with their free cash flow. Diluted shares outstanding (3.1mm) has only slightly increased due to four annual 10% stock dividends and some minimal option issuance. From 1998 to 2002, operating margins have expanded from 8% to 12%, ROE remained above 20% and 2003 looks like an across the board improvement.


1998 2002 9M2003

Net Sales 25.9 59.0 50.0
Net Income 2.1 4.2 4.6
Long Term Debt 1.6 0.1 0
Shareholders Equity 11.3 19.8 25.8
Orders on hand 16.2 34.7 NA

Gross Margins 25% 31%
Operating Margins 8% 12%
After Tax ROE 22% 21%


Now that the background has been laid out, here are the highlights of the investment thesis:

NOL carry forwards – The Company will not be paying any U.S. federal income tax for the at least the next few years due to a $21mm NOL carry forward it had going into 2003. Because they do business outside the U.S., this shielded 70% of their net income from taxes in 2002. While I expect final 2003 reported net income to be in the $6-$7mm dollar range, cash net earnings will be closer to $8-$9mm (D&A roughly matches maintenance CAPEX).

Buyout or Merger – The Company announced earlier this year that they had engaged William Blair to “explore strategic alternatives.” The CFO (who tried to avoid my calls) told me that they are still engaged. When I asked him if they were looking to buy or get bought, he told me “that is why we hired William Blair.” My take is that HKW (who are directors of the company and have been buying shares all year) are pushing for a buyout (rare for them to hold a position for longer than five years).

Orphaned stock – The Company holds no conference calls, has only two institutional shareholders, and has no analyst coverage.

Management – I spoke to one of the Principals at HKW, who obviously had only great things to say about management. What I do know is that they are very non promotional and that Michael Furry, the CEO, writes one of the most unusual shareholder letters I have ever read (a close second to Expeditor International). Furry’s operating performance and shareholder performance speaks for itself.

Valuation:

On just a free cash flow basis, you are getting a yield above 10% for a company that is growing over 20% on a small base and in a sector that is growing and fairly recession proof.

I have run a five year conservative base case DCF scenario to arrive at an intrinsic value range of $29-$31 a share while not taking into account the value of the NOL’S. I have presented the summary form here.

Base Case:

Assumptions

Yearly revenue growth: 15%
Net Operating margin: 12%
Investment Rate as % of revenue: 4%
Depreciation as % of revenue: 2.7%
Working cap as % of revenue: 20%
WACC: 10%

For the base case model, the 5th year revenue is $137mm and NOPAT is $10mm. After year five, I assume the company earns their cost of capital. I have also included the companies long term pension liabilities of $5.8mm although the Company expects this to reverse (went up in 2001 and 2002 due to stock market losses).

Output ($mm):

Discounted 5 year FCFF: $13.2
Discounted Corporate Residual Value: $66.5
Plus Short Term Assets: $24.0
Less Debt: -
Less Preferred Stock: -
Less ST, Pension Liabilities: ($13.80)
Total Value to Common Equity: $89.8
Intrinsic Stock Value: $29
Potential Return 38%

It should be noted that if you use the 8% WACC that CAPM suggests you get a value of $36 dollars or 71% upside at today’s prices.

Risks include:

Customer concentration
Light trading volume

Catalyst

Valuation
Buyout
Continued profitable growth
Wall Street recognition
Cash to buy back stock now that all the debt has been paid off