Hello and happy 2013! To start this year off right, I present to you a high quality unlisted industrial company – Quality Products Inc.
Quality Products is a true rarity: a tiny company that manages enormous gross and operating margins, high returns on capital and consistent free cash flow. Even better, the company uses its prodigious cash flow to repurchase shares and pay large special dividends.
Quality Products operates two subsidiaries: Multi-Press and Columbus Jack. Multi-Press manufactures and services a variety of large industrial presses like this and this. Multi-Press has been in business for 65 years and was acquired by Quality Products in 1989. Columbus Jack manufactures and services many types of aircraft jacks and other runway equipment for commercial and military customers. Columbus Jack was founded in the 1940s and purchased by Quality Products in 2001. Both these subsidiaries are located in the Columbus, Ohio area. Quality Products also owns nearly $5 million in investments including private equity and real estate.
Both of Quality Products’ subsidiaries are profitable and growing, but Columbus Jack is the real gem. Between 2004 and 2012, revenues for Columbus Jack rose 151% while revenues at Multi-Press rose 49%. Over the time period, Columbus Jack’s gross margin rose to an incredible 50.30%, a nearly unheard of level for a manufacturing company.
While Quality Products’ long-term revenue growth is high, recent revenue growth has slowed. Profit growth since 2007 has largely been realized through improvements in gross margins, as well as income from royalties related to government defense projects and gains on the company’s private investment portfolio. 2009’s record profits benefited from the reduction of a valuation allowance on the company’s net operating losses from previous unprofitable years.
While the company’s bottom-line profits may have retreated slightly from the 2009-2011 period, earnings per share have been buoyed by the company’s aggressive share repurchase program. Since 2006, the company has reduced shares outstanding by 43.6%.
From 2007 to 2012, Quality Products produced total free cash flow of $34.7 million, exceeding its net income by $5 million. In addition to its share repurchases, Quality Products paid large special dividends in each of the past three years, funding them through its operating cash flow, proceeds from its investment portfolio and its line of credit.
Quality Products’ total debt and pension obligation stands at $5.90 million, less than 1x trailing EBITDA. This debt is offset by $7.63 million in cash and investments. Clearly, the company’s debt load is manageable and could even be increased to fund future share repurchases or dividend without endangering the company’s stability. The company’s current ratio is 3.49, indicating solid near-term liquidity.
The company makes excellent use of its assets, achieving a return on equity of 34% in 2012. This figure was earned via a profit margin of 21.25%, asset turnover of 1.11 and assets/equity of 1.44. Pre-tax return on assets was 36.3%.
Despite Quality Products’ robust margins and high earnings quality, the company trades at a very modest valuation. With a share price mid-point of $14.25 and a market capitalization of $34.2 million, the company has a trailing P/E ratio of 7.8. Free cash flow yield is 13.4%. The company trades at a substantial premium to book value, but its consistently excellent profitability and strong financing helps to justify the premium. The company’s large non-core investment portfolio also provides upside potential as these investments produce gains or are liquidated and the proceeds used to repurchase shares or pay dividends.
The biggest risks facing Quality Products Inc. are the possibilities of reduced military spending and the usual risks that accompany being an illiquid, insider-controlled company. Columbus Jack’s revenues are highly dependent on sales to military customers, which provide the majority of its revenues. In each of the last few annual earnings reports, the company has warned that it does not consider the Columbus Jack segment’s gross margins to be sustainable. It is worth monitoring the US government’s budget discussions to determine any possible impact on Quality Products’ revenues.
Shares of the company are highly illiquid with less than 1% of shares outstanding changing hands in the last three months. Trading prices have exhibited some wild moves, peaking at $42 per share in January 2012. Caution should be used in buying and selling. Quality Products is controlled by insiders. The last complete annual report filed with the SEC (2004) lists 37.5% of shares as controlled by insiders and one additional shareholder. Due to share repurchases, these same shareholders now control 63.4% of shares outstanding assuming they did not sell any.
Disclosure: No position.