In my recent article on National Presto Industries (NPK), I estimated that the acquisition price for DSE would not exceed $9mm. In the last week, an SA reader noted that a local newspaper just reported the amount NPK paid: it was $47mm. The number is confirmed in the recently released NPK 10-Q for 2013Q3. Although the deal is significantly larger than I had expected, I think NPK paid a fair price. The overall investment thesis remains intact.
I estimated the DSE acquisition based on a scenario of a fire sale of the assets from a distressed company. In hindsight, the deal works more like a normal course of business acquisition. What I missed was the sizeable order backlog DSE has for the US Army's 40mm system contract. Given the historical 60/40 order split between the two primary contractors (AMTEC and DSE), the size of DSE order backlog ($187mm) is in line with those held by AMTEC ($310mm). In the table below, I have shown the return analysis on the DSE acquisition.
I assumed that the order backlog will be delivered evenly in the next three years. Using NPK defense segment's margin, $187mm order is projected to generate a total net profit of $24mm. From 2017 onward, the revenue acquired is estimated to be 40% of the Army's 40mm system budget in FY17. With these assumptions, the internal rate of return on the deal is 10%.
This return number is lower than NPK's own FCF on equity, which averages 12% between 2010 and 2012. But we have not factored in any tax benefit from depreciation, synergy or cost saving into the deal. Other than economic return, NPK may have other consideration for this deal. DSE closed the door, despite having a big order at hand. It must be in some sort of financial distress. If NPK did not buy DSE, other defense companies might acquire it and assume its order backlog. NPK will continue to be one of the two primary contractors for the 40mm system and depending on the strength of the acquirer, might see this 60/40 allocation tilted toward the other direction.
With the acquired revenue, NPK can put off the sales slump from 40mm system for 2-3 years (see the forecast below). It will give its other businesses such as non-lethal weapon and absorbent products more time to grow the revenue and make up the order reduction from the Army.
The DSE purchase can be viewed as the deployment of half of the cash and equivalent on the balance sheet. I have estimated that from 2014 to 2020, NPK can generate a potential average of $46mm FCF per year, or $6.77/share. Management should be able to maintain a dividend at $6-6.5/share for the next 5-7 years and add another $10-12mm to the cash balance by the end of the period. The following table shows the updated stock valuation analysis. It has incorporated some tax benefits from the amortization of the acquired assets.