Microcaps are not for the faint of heart. The same thing that can give a small investor like myself an edge also leads to volatility around earnings time. Many small and microcaps don’t do much to keep investors in the loop regarding business updates (especially when they are negative). They also lack institutional following to assist in the information dissemination process.
I was recently reminded of such volatility when MUEL reported earnings a few days ago. The share price responded by dropping nearly 30% on the day. Since the shares started the week pretty much where I originally purchased them, I am essentially down 30% on my position. I need to re-evaluate the position and make a decision to add, maintain or sell.
Here is a quick rundown on the business segments.
- Dairy Farm Equipment
- Milk cooling and storage for dairy farms
- Processing and storage tanks
- Refrigeration products
- Heat transfer equipment
- Standard and customized stainless steel and alloy processing and storage tanks
- Pure water equipment
- Heat transfer products
- Over the road tank trailers
- Field Fabrication
- Large field erected tanks/vessels
- Equipment installation
- Process piping
- Retrofit and/or repair of process systems
- Turnkey design and construction of compete processing plants
- Delivery of products and components to customers and field fabrication sites
- Backhauls of materials and contract carriage
The original thesis was a function of a few different factors (those interested should check out OTC Adventures latest post on MUEL):
- Continued deleverage of the balance sheet, including:
- minimal impact from the company’s pension liabilities
- pay down of debt (or at least not increasing leverage)
- management of working capital
- Execution of the largest reporting segments (Dairy and Industrial), including:
- continued execution on the Dairy segment
- progress on turning around of Industrial segment
- overall margins on a consolidated basis
- strong message from CEO on the other segments
I am no expert on company pensions. Over the years I have strayed away from companies that have large pension liabilities. For the most part, they have a ticking time bomb feeling to them. But that is truly an unfair statement. There are companies that have defined benefit pensions that are not underfunded or at the very least are not dramatically underfunded enough to be a worry.
What I have decided is good enough for me in order to pursue an investment in the company is:
- pension that is not enormous enough to distract the company’s management team from executing on growing the business. it should be mentioned that the size of the obligation can be crudely modelled into a fair value for the stock
- conservatively valued (low discount rate and return expectations)
- underlying investments are not “junky” or high risk
- most importantly, management recognizes the potential risk and puts appropriate measures to mitigate risks involved
MUEL seems to have this part under control in my mind. The size of the obligation is high, but there is little mention of it by the CEO in the letters to shareholders and (due to the next few points) I don’t think it consumes a ton of management attention.
Discount rates currently at 5.34% and expected return is 6.78%. Seems reasonable over the long term. It should be noted that both have been trending down over the last 6 years.
Investments in the plan are a mix of equities and fixed income. Equities include a broad range of publicly traded securities (including US listed and ADRs). Fixed income is made up of high quality corporate debt and government debt. Currently 61% of the plan is in equities and 38% in fixed income. It passes this test for me.
Lastly, there has been some initiatives put into place to reduce the total liability over the long term. There is a couple of moving pieces here, here’s the language from the latest 10-k.
You can see the initiative bearing fruit as the service cost under the benefit obligation summary has been zero for the last 3 years.
Overall, I am mindful of the pension liability, but feel the right measures are in place to simply include some form of the obligation into the valuation of MUEL.
Pay Down of Debt
Given the pension liability, I view this as important to minimize balance sheet leverage. In this instance management has been executing for the last number of years.
Working Capital Management
There have been stories of some businesses running into hard times simply because they don’t manage their working capital. Here I look at 2 metrics; CCC and working capital as % of TTM rev. To be fair, I haven’t smoothed these numbers out to take an average amount over the course of a year, so they are not perfect. But from my vantage point, they are enough to show that the company is not in a risky position with it’s working capital.
Overall I am happy with MUEL deleveraging the balance sheet. The main sore spot over the last year has been the pension obligation increasing on the liability side of the balance sheet.
The Diary and Industrial segments have been 80-90% of revenue for the past 6 years. So if you wanted to see what will move the needle, you need to understand the underlying mechanics of each and have confidence in execution.
A couple of acquisitions in 2008 changed the segment dramatically. Sales rose dramatically due to the acquisitions. Since 2008, sales have been between 70-90 mil with EBITDA slowly expanding to the 15 mil mark in 2014. This is the most valuable part of the business by far. Having said that, starting in 2015 there will no longer be a quota on mild production in Europe. This will impact the Diary business to a large degree. At this point, it seems to be a short term non-event with a medium term tailwind. You can read about it here. Something to monitor for sure.
The other large segment is the Industrial segment. Results have not been good over the last 10 years.
There is no surprise something labelled Industrial is cyclical. Part of the reason I invest in small companies is that expect them to be nimble to a certain degree. The other part is that I would the CEO to be able to make change to culture of the business in shorter order than a larger company.
Processing Equipment is the largest part of this segment. In 2013 the Processing Equipment portion earning 6.3 in pretax profit on better efficiencies and margins, meaning the remaining parts of the business lost around 8.1 mil. In 2014, the Industrial segment as a whole lost 0.652 mil and the Processing Equipment had a “small loss”. One can infer that the other Industrial portions of the segment were around breakeven. That’s quite an improvement. This is confirmed in the letter to shareholders with the statements being generally positive with the other parts of the Industrial segment.
I do have a concern with the Industrial segment on a consolidated basis. I would assume that some tough decisions are in order for this part of the business as the CEO has now been in place for 2 years and yet the Industrial segment is not performing.
Gross margins are down in Q4 2014 from a year ago. As the chart shows, given the low gross margins inherent in the business, one needs to be really comfortable with the management team’s focus on doing business that makes sense financially and not “making work” to stay busy which is a struggle for many production related businesses with unionized labour.
CEO Message Around Business Culture and Shareholder Interests
The company doesn’t have quarterly conference calls, and doesn’t participate in investing conferences. However, the annual letter to shareholders does set a tone of accountability by naming the various manager of the various divisions. It also mentions revenue and margins to some degree, but does not give exact numbers for analysis purposes. Also, managers compensation is more closely tied to the business segments in which they are responsible for.
There is mention of efficiencies in processes and right sizing of headcount a few times. For this to be talked about openly is a positive and gives at least some confidence that the management team can make tough decisions if needed.
Other things of importance
- The other 2 segments (field ops and transportation) are performing well except an accident at a customer site with a field fabricated unit where the company has taken a 2.9 mil reserve against the accident
- MUEL used to pay a dividend, but stopped in 2009
- Lower Euro hurts the Diary operations in Europe
- Backlog is down from a year ago, but within is last 3 year range
- David Moore has taken over as CEO in 2013, he has been with the company since the late 90s
I think the best valuation metric for this type of potential investment is either EV/EBIT or EV/FCF.
Including the pension in the calculation is up for debate. Something should be included in my opinion. How much, I’m not sure. Given the way pensions are calculated leads to wild swings in value. This is why it makes no sense to use book value as a metric for this business. I think given the ROC potential (20%+), even just the crude measure of including the entire liability still makes this company cheap.
As far as upside goes, one could paint a picture with continued strength in Dairy and some modest profit from Industrial. Couple this together with some operating earnings from Field Ops and Transportation, I could get to 16 mil in operating earnings. This would put current shares at 4.14 EV/EBIT or 6.35 EV/EBIT if you include the pension obligation. If the business is earning those kinds of margins, I would think a valuation almost double today’s would be fair.
There are some things I need to understand before making any sort of a move:
- Increased context on the pension calculation and more information on the employees on the defined benefit plan. What does this look like on a go-forward basis
- More information on the accident that caused the 2.9mil provision. Specifically, what is the company’s risk mitigation strategy when one accident can make up a reserve charge that equal to 20% of the segment’s revenue
- What is going to be done with the Industrial segment and when can we expect some sort of stability in that business
- Additional context on the milk quota removal and what it means to the dairy segment
- Some color on the backlog
I plan on attempting to contact management over the next week or two to get this information over the phone.
Feel free to comment.
The author is currently long MUEL, but that can change at any moment, so do your homework.