Pental Limited – PTL:ASX

The market values companies from various economic sectors at widely different multiples of earnings, assets and cash flows, and for good reason. In general, non-cyclical sectors receive higher valuations, while industries that are strongly exposed to the business cycle receive lower valuations. It’s a function of cost of capital; industries with deeply cyclical and/or unpredictable revenues and earnings are riskier, and therefore carry a higher cost of capital. Finance 101. One of the most stable market sectors is consumer staples, and that stability is usually reflected in the valuations of companies selling ordinary, necessary products.  Manufacturers of toothpaste, soap, cereal, and like products deserve their premium valuation, because consumers will continue to purchase these products in all but the most extreme economic climates.

For this reason, I pay particular attention when I find a healthy consumer staples company trading at a large discount to market averages, let alone the premium valuation that its peers receive. Today’s example is Pental Limited. Pental is an Australian manufacturer of several household brands, including White King bleach, Huggie fabric conditioner, Martha’s wool cleaner and AIM toothpaste, among other brands. Most of Pental’s products are well-known in Australia and New Zealand and command high market share. Household cleaning is Pental’s leading product category, followed by private label products, then personal care products.

Pental has a broad set of quality product offerings, little debt and reasonable operating margins, yet the company trades at a single digit P/E and a discount to book value. In my view, this humble valuation is caused by two major factors.

Outdated Market Perceptions – Until recently, Pental was a highly distressed and indebted company. Then known as Symex, the company operated a specialty chemicals business in addition to its household products business. The chemicals business once produced substantial profits. However, 2012 saw earnings hammered by rising input costs, a strong Australian Dollar, and strong competition. Symex’s large debt load suddenly threatened the company’s existence. At June 30, 2012, Symex carried AUD 59.70 million in net debt, more than ten times the fiscal year’s EBITDA. As part of an agreement with its bankers, Symex agreed to take a number of steps to reduce its debt, including selling off real estate holdings, raising equity capital, and securing receivables financing.

By the end of 2012, the company (now renamed Pental) had succeeded in raising AUD 17.55 million in equity capital, closed down the specialty chemicals business and sold associated real estate, and made principal repayments on its debt. In return for succeeding with these initiatives, the company’s lender wrote off AUD 10 million in debt. The company secured a new credit agreement expiring in 2015. The company also reported improved profitability in its consumer products business.

Today, Pental has reduced its net debt to just AUD 4.70 million, less than half of trailing EBITDA. Consumer products sales and earnings are on the rise, and the company is constructing new bleach manufacturing facilities, which should reduce costs and increase capacity. The market, however, still treats Pental as the heavily indebted and struggling company that is was a year ago.

Capital Structure – In order to fund its equity capital raising, Pental undertook multiple initiatives. The first was a simple share sale to a strategic investor. Concurrent with the share sale, Pental made a rights issue to its shareholders of seven purchase rights per share. These rights, allowed the purchase of one Pental share at AUD 0.015 per right. Three months after the expiration of these rights, Pental distributed one “loyalty option” for each four shares of Pental, which entitled investors to buy one share of Pental for AUD 0.02 for the following 18 months. Finally, Pental encouraged holders of these loyalty options to exercise the options by distributing “Piggyback Options.” For every loyalty option exercised before November 30, 2013, Pental issued one “Piggyback Option.” These piggyback options allow the purchase of one share of Pental at AUD 0.03 for the following 18 months.

Complicated enough?  After all those moves, Pental has 1,504.58 million shares outstanding. It also has 87.61 million loyalty options still outstanding with a strike of AUD 0.02, plus 287.57 million piggyback options with a strike of AUD 0.03. Estimating a fair value for Pental’s shares requires adjusting for options exercise, which may obfuscate Pental’s worth.

For the twelve trailing months, Pental reported adjusted EBITDA of AUD 10.66 million and EBIT of AUD 9.11 million. (Results in the first half of fiscal 2014 were substantially improved over the first half of 2013, but I’ll refrain from annualizing these in the interest of conservatism.) Reported net income from continuing operations was AUD 4.97 million for the trailing twelve months. Computing Pental’s trailing valuation requires adjusting for the exercise of Pental’s loyalty options. At Pental’s current share price of AUD 0.027, the piggyback options are anti-dilutive. Full exercise of the loyalty options would raise AUD 1.75 million in cash for Pental.

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4.3x EBITDA and 5.0x EBIT is a bargain valuation for a growing consumer staples company with little debt and market-leading products. Moreover, Pental’s already conservatively-estimated results are likely to improve once its new or upgraded production facilities are fully online. Already, the company has won new private label production contracts for Woolworths, Aldi, and Coles on the basis of its new, more efficient bleach plant.

Were the market to value Pental at a more conventional multiples of EBITDA, Pental shares could see significant appreciation. The chart below displays potential share prices and appreciation at various EBITDA multiples, assuming full options exercise. Worth noting is the fact that many other basic consumer products producers currently trade at double-digit EBITDA multiples.

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Pental is considering reinstating its dividend in 2014, which could lead investors to take a second look at the company’s much-improved balance sheet and improving profits. The company’s loyalty options expire in late 2014, which will serve to simplify the capital structure and will further reduce net indebtedness. Combined with continued revenue and profit growth, Pental shares could be significantly higher a year hence.

Alluvial Capital Managment, LLC does not hold shares of Pental Limited  for client accounts.

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

Holland Colours NV – HOLCO:Amsterdam

Holland Colours (“Holco”) is a tiny Dutch manufacturer of industrial coloring agents and pigments. The company has high employee ownership, operates in a profitable niche market and produces consistent free cash flow, all things I love to see in a company. Holland Colours also trades at a undemanding multiple of earnings, pays a generous dividend and has room for growth.

Holland Colours was founded in 1979 in Apeldoorn, Netherlands. The company’s first product (and still its major source of revenue) was Holcobatch, an easy to use coloring agent for use with plastics and other synthetic materials, especially PVC. Holcobatch can be used to create practically any color imaginable, and is simpler to handle than powder pigments and liquid dyes.

Holcobatch
Holcobatch

Holland Colours also produces Holcoprill for other plastics and Holcosil paste for silicone products. The company’s largest customer is the construction and building industry, which uses the company’s products to colorize PVC pipes, door and window housings, siding and other plastic components. Holco’s products are also used in packaging, as well as in silicones and elastomers like sealants and  rubber, and finally in specialty applications like polystyrene foams and fibers. Since its founding, Holland Colours has grown into a worldwide company employing around 400. The company has manufacturing facilities in the US, Europe and Asia. Holco’s product lines are not long-term high-growth industries , but demand should generally increase in line with world GDP over time. As always, low long-term growth is neither automatically good nor bad. Low growth limits potential company profits, but also discourages new suppliers from entering the market and reduces the chances of innovative disruption.

The financial crisis took a toll on Holco’s revenues and earnings, but the company has fully recovered. The company manages a healthy gross margin in the mid 40s, and also converts an impressive proportion of its net income to free cash flow. Here’s a look at the company’s results since 2007. All figures are in millions of Euros, and will be for the entirety of this post.

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Trailing twelve months results remain slightly below 2011 earnings, when some pent-up demand combined with low materials costs gave Holco some additional earning power. However, the company’s EBIT margin has nearly caught up with pre-crisis figures. From 2007 through fiscal 2013, total net income to free cash flow conversion was 148%, with EUR 16.3 million in free cash flow from EUR 11.0 million in net income.

So where did all that excess free cash flow come from? The answer can be found by comparing Holco’s historical depreciation and amortization with its historical capital expenditures. From 2009 to 2013, Holco seemingly underinvested in its long-term assets, with annual capital expenditures coming in well below recorded depreciation and amortization. Ordinarily, this might be cause for concern. After all, a company that continually underinvests in necessary physical assets will eventually see its competitive and financial positions eroded through production delays and costly repairs. But I don’t think that’s the case with Holland Colours. For one, the company’s main source of revenue, the European building and construction industry, has struggled mightily for the past several years. In times of low utilization, physical plant wears out more slowly and may not require replacement at the same frequency. Second, Holcobatch production has been going on for decades, and the process is unlikely to change, requiring new machinery or facilities. Combine depressed utilization and a stable production process and you get low capital expenditure requirements. Regardless, Holco management has now reversed the low capital expenditure trend, investing 1.15x the amount of depreciation and amortization in capital assets for the twelve trailing months.

Holco has used its copious free cash flow to chip away at its debt, resulting in a much more stable and sustainable company. Should another crisis or extended recession come along, Holland Colours will likely fare much better than it did the last time around.
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Now for a look at Holco’s valuation. As I write, the company has a market cap of EUR 25.8 million. However, only about EUR 5.8 million worth of shares are free floating. Just over half the company’s shares are controlled by Holland Pigments BV, in which many Holco employees are invested. (In all, Holco employees own 21% of the company.) Various other institutions own large blocks of shares, leaving only 22.6% of the company’s shares available for investment. The micro float of an already microcap company may partially explain Holland Colours’ low valuation.

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Generally speaking, buying consistent free cash flow generators with defensible business models at single digit EBIT/earnings multiples tends to work out well, whether or not a company experiences revenue growth. Either revenue growth does occur, operating leverage kicks in and the value of the company increases without multiple expansion, or market perception changes, and the company is awarded a higher multiple of the same steady earnings and cash flow. Ideally, both processes occur at the same time, and that’s where investors can really make some great returns. At the moment, Holdco’s valuation may be held back by the market’s perception of its home Eurozone economy: financially strapped, with little growth and with no recovery in building and construction within sight. However, Holland Colours actually generates more than 75% of its EBIT in the healthier economic climates of the Americas and Asia.

Year by year, Holco has been reducing its dependence on the struggling markets of Europe and building its business in the Americas and Asia. While the company still receives more than half its revenues from Europe, this figure is down substantially from 2008. Asia’s contribution to revenues nearly doubled from 2008 to present, while the Americas rose slightly.

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While Europe’s significance to Holco’s revenues has decreased, the region’s significance to EBIT has truly plunged. In 2008, Europe accounted for over half of Holland Colours’ EBIT; now, it account for less than one quarter. The Americas (chiefly the US and Canada) have come on strong and now account for more than half of Holco’s EBIT. Asia contributes more, but not in proportion to its revenue growth. Holco has had some sales and profitability issues in China, but is attempting to address these through better staffing.

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While Holco’s European operations struggle to earn an EBIT margin of more than a few percentage points above breakeven, the Americas segment is ticking along at an EBIT margin of 11.9%, while Asia is at 13.5%. There are a few possibilities here that could result in greatly improved profits for Holco.

  1. Europe continues to struggle, but Holco’s focus on Asia and the Americas continues to pay off. European revenues soon dip below a 50% share and continue to fall, eventually leading the market to recognize that Holco should no longer be given a Eurozone valuation.
  2. Europe’s long-awaited economy recovery arrives, complete with a resumption of normal building and construction activity. European revenues and profitability take off, complementing the company’s successful international operations.

Either scenario would result in greatly expanded profits and likely, a large increase in the value of Holco stock. On the other hand, slowdowns in Asia and the Americas with a continued European malaise could result in returns to 2008/2010 level results, though Holco’s lower indebtedness would somewhat reduce the sting this time around. While they wait to see which scenario plays out, investors will be well-rewarded in dividends. At the current price of EUR 30, Holland Colours yields 5.7%.

Alluvial Capital Managment, LLC holds shares of Holland Colours NV for client accounts.

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.