Park-Ohio Holdings Corp., a manufacturing and supply chain company, has been on Inverness’s watchlist for a little while and is a bit of an unconventional play for the value investor. However, the story is quite intriguing, and some of you more risk-forward investors might like to take a peek. Disclaimer: Inverness is well-aware of the recent 70% growth in the stock, so value investors beware.
Founded in 1907 as Park-Ohio Industries, PKOH is a supply chain outsourcing company and custom component manufacturer for aerospace, automotive, and other industrial original equipment manufacturing (OEM) customers. It is well-diversified with 17 manufacturing brands across three business lines: Supply Technologies (38%), Assembly Components (33%), and Engineered Products (29%). The business does 66% of its business in the US, 12% in Europe, and the remainder in Canada, Mexico, and Asia. CEO Matthew Crawford, 50, took over in 2018 – his father was the former chairman – and as of 12/31/19, PKOH employed approximately 7,100 people.
The company hangs its hat on supply chain management and custom engineered products, but the story here is more about the vulnerabilities to the business. A concentration in the Assembly Components business (five AC customers account for roughly 50% of AC revenue, impacting about 15-20% of the total revenue base), asbestos rulings and suits, and manufacturing’s inherent cyclical business are all good reasons to scoff at PKOH. The business model exhibits narrow margins, the products highly are specific and revenue visibility is low.
The company operates what those in leveraged finance might call a “lumpy” revenue model. Components are manufactured according to large, negotiated contracts and custom builds for other parts, and bid out to multiple different Original Equipment Manufacturers (OEMs) or brought to PKOH from a sales network. From the bank lender’s perspective (PKOH holds over $500mm in debt), this chunkiness causes probability of on-time principal and interest payments to decline for a given quarter, driving revenue to trough more often than a consistent widget production schedule, like the iPhone for example. A miss of a payment would trip covenants and cause all sorts of restructuring problems for the bank, including running up against regulatory scrutiny for loose lending practices or having to take ownership of assets that lose money in batches.
The balance sheet is a little weaker than Inverness would typically like to see. With a $500mm debt burden compared to $50mm[1] of cash, the company could struggle if hit with another industry body blow, as the gross margin contraction drove net leverage to 11-12x.[2] On our customary liquidation valuation analysis, net liquidation value is -$520mm, about equal to the debt burden of $529mm and leaving no room for equity holders after a bankruptcy scenario. See below for an analysis of market cap compared to liquidation value:
Cash was excluded from this analysis because it is assumed to reach $0 in a bankruptcy scenario.
While margin of safety might not be the best measure of value here, be not afraid for Park-Ohio. The management team invested $130mm over 2018 and 2019 to purchase tuck-in acquisitions and double annual capex to $40mm. The team has now been battle-tested because of 2020, and Inverness expects overhead to decline as coronavirus abates and work-from-home becomes the norm for corporate staff. As a result, PKOH’s margins should expand and leverage should abate, and the market will continue to reward the 357 PKOH shareholders of record as things return to normal. Further mitigating the operating risks are PKOH’s broad 8700-customer base with over 200k stock keeping units (SKUs). The average customer relationship is at least 10 years, and the company’s lumpiest segment would impact only 15-20% of the business.
During the depths of 2020 PKOH was trading around 9-year lows, but has risen ~70% in the past couple months on the recent optimism of corona season and performance improvements. PKOH had a profitable third quarter, making up for weakness in the first half of 2020 and sending YTD 9/30/2020 EBITDA to $30mm. Yes, revenue dropped by almost a third from 2019 to 2020, but what matters to us is that the business is able to keep on chugging through tough environments, remaining profitable and continuing to create value for its customers. The company is now looking at $1.2 billion of 2020 projected revenue and $43mm of EBITDA in a tough year. No mean feat.
With its 113-year operating history, PKOH has demonstrated its durability through the business cycle. Management passed a major test in 2020 and seems to have come out right with the pack, if not a bit ahead by virtue of being merely profitable. Yes, the balance sheet is a little upside down, but operations are recovering and the company should benefit when it demonstrates in the near term that it has dug itself out of its corona hole. These are all things to be optimistic about, and did we mention that the company also pays a 1.8% dividend? Inverness would like to own some.
Disclaimer: Inverness Holdings does not own any interest in PKOH.
Sources: company 10-ks
[1] which would cover about 4-5 months of overhead, assuming capex, debt payments, and dividends get halted or restructured to $0
[2] Gross margin lost about 320 basis points in 2020, driving estimated 2020 EBITDA margins to 3.4%, versus a historical baseline of 7-8% (2017-19) and 1/3 of 2018-19 levels on an absolute basis.